Making Sense of the Merge: What’s Next for Ethereum
The Merge. What is it? Why is it a big deal? And how does it affect you? In the most simplistic sense, the Merge saw Ethereum absorb another blockchain in order to change how transactions take place. However, the importance of this move cannot be underestimated as it alters the sustainability, scalability, security and decentralisation of Ethereum.
To understand the Merge, you first need to know how the Ethereum blockchain works. At its core, Ethereum relies on a consensus mechanism – which allows the approval of new block creation. Before the Merge, this was an energy-intensive mining operation called Proof-of-Work (PoW). Now, it’s a more energy-efficient process referred to as Proof-of-Stake (PoS). Let’s break down what this means in practice and for your investments.
- Ethereum’s shift to PoS is a critical step toward increasing the network’s scalability, while simultaneously improving its sustainably.
- The economies of scale associated with PoW mining disappear under PoS. Lower barriers to entry attract more users to the network, and because of the lack of mining infrastructure, the security cost around block rewards can be reduced, democratising network security and reducing new ether (ETH) supply.
- PoS makes ETH a stronger, more diverse asset which can generate yield through network security and blockchain value creation. Also, with stronger supply and demand mechanisms, ETH has the potential to be a deflationary asset.
The Beacon of Hope
The Merge didn’t come out of left field. While PoW was critical to get the network up and running, Vitalik Buterin, the programmer who introduced Ethereum’s original blockchain, always envisioned a change in its consensus mechanism.
Before the Merge, two independent blockchains were using Ethereum code in parallel. While Ethereum took centre stage, the Beacon Chain ran in the background and proved PoS – which relies on staking ETH rather than PoW mining to prevent sybil attacks and support consensus on the state of the network – was a valid system. When the Beacon Chain was successfully shipped on September 15, 2022, it preserved Ethereum’s economic ecosystem and historical data while simultaneously implementing PoS.
Life After the Merge
With the Merge done and dusted, there are five key outcomes which will evolve Ethereum.
- Going Eco-friendly
PoS is estimated to reduce Ethereum’s energy footprint by at least 99%.1 How? PoS requires participants to post ETH as collateral in a practice called staking, whereas PoW kept network validators accountable by tying up capital in hardware and electricity expenses to disincentivise malicious behaviour when validating transactions. In turn, it significantly reduces the amount of emissions generated from mining on the network – an important move in today’s energy-conscious world.
- Prioritising Decentralisation
PoW’s reliance on large input costs introduced considerable economies of scale. Left unchanged, this had the potential to concentrate control of the network to a small pool of participants capable of setting up the necessary infrastructure. PoS levels the playing field by getting validators to stake ETH. While large institutional players will likely benefit from the cost efficiencies of prime broker relationships, large block purchases also incur implicit transaction costs. Therefore, neither individuals nor institutions have a significant cost advantage in becoming validators or acquiring ETH. Additionally, PoS equally compensates contributors in relation to their share size of the network’s staked tokens.
- Increasing Economic Security
Ethereum’s transition to PoS will strengthen security as barriers to entry lower, users diversify and staked capital increases. Even at current levels a hijacker would need at least $10 billion – a 51% stake – to attack Ethereum and it will become exponentially more difficult as the network grows.2 Slashing is another prominent security feature of PoS. It empowers the network to respond to validators who act in a provably malicious manner by seizing a portion of their staked assets or by removing them from the chain entirely – incentivising validators to follow protocol rules and act in the network’s best interest.
- Minimising Token Inflation
Given PoW required significant input from validators, Ethereum compensated their efforts by issuing them newly minted tokens for each transaction – creating the need for inflationary monetary policies. PoS costs for validators are much lower, so Ethereum will pay validators fewer rewards for providing the same level of network security. This will shake up Ethereum’s monetary policy, as the daily issuance of new tokens used to pay for network security declined around 90% from roughly 13,000 to 1,600 ETH per day. Resulting in a drastic shift in annualised token inflation from about 4% to less than 0.5% following the Merge.3
- Becoming Bigger and Better
The Merge enables a path toward Ethereum’s long-term goals: shard chains which support scalability. Sharded chains cut down the network’s computational burden by essentially splitting it into smaller components. In time, this will allow validators to use cheap consumer hardware, promoting global participation and network decentralisation. Sharding has the potential to grow Ethereum’s transactional capacity to over 100,000 transactions per second. The Merge was crucial because sharding is only possible on a PoS-based system.
Will ETH Become a Better Asset?
Yes! If you’re comparing it to money in a traditional sense. The strongest forms of money serve as a store of value, a unit of account with an ecosystem depending on its utility, a widely trusted and accepted medium of exchange, and an asset capable of generating real yield derived from its demand. 4
Arguably, Ethereum’s transition to PoS helps ETH check all these boxes, and then some. With PoS, ETH becomes stronger because it can act as:
- A store of value asset due to its supply and demand mechanisms.
- A unit of account and strong commodity within its digital economy.
- A strongly adopted medium of exchange within its ecosystem.
- A multi-functional yield-generating asset.
Ethereum is also looking ahead to advancements which could define ETH as a unique digital asset. For instance, Ethereum Improvement Proposal’s (EIPs) which promote deflationary behaviour. EIP-1559 introduced a mechanism which “burns” a portion of each transaction’s gas fees. In effect, as more transactions are conducted on-chain, more gas is burned, and more ETH is permanently removed from circulation. Combined with the reduction of new tokens, PoS has the potential to make ETH deflationary over the long run.
With PoS in place, generating yield will become a more attractive feature of ETH. Block rewards, cash flows from block tips, and on-chain arbitrage activity will all accrue to staked ETH tokens and will be paid to staking participants in the form of a real yield.
One Small Step for PoS, One Giant Leap for Ethereum
All that being said, how will it affect your holdings? If you directly own ETH in your digital wallet, the key difference is whether you want to start “staking” your currency in the PoS consensus mechanism or just sit on the sidelines. For those investing via ETFs, it all depends on the funds’ structure. However, if the ETF is holding tokens directly in cold storage, they will not be subject to any changes bar the ebbs and flows of ETH’s value. Hence, its important to consider how ongoing advancements in the Ethereum network brought on by the Merge will impact ETH as an asset into the future.
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