Translated by LC and elcreto

Summary

• The Ethereum Merge, a multi-year event designed to upgrade the network from a PoW to a PoS consensus mechanism, is estimated to go live around Sep 10 – 20, 2022, and the ETH price has climbed more than 50%+ from the year-to-date low as of writing.
• The price increase reflects the expectations for the ETH supply to decrease after switching to the PoS consensus mechanism.
• After the Ether Merge upgrade, i) fee reduction or 2) increase in transaction processing speed will occur only when the Ethereum ecosystem continues to expand, focusing on rollups or upon the completion of the sharding implementation.
• A conservative investment approach is recommended as the ETH price is expected to be highly volatile before and after the Merge.

The Ethereum Merge: The Shift to a PoS Consensus Mechanism 

Ethereum's founder Vitalik Buterin and Ethereum were natually the star of the Korea Blockchain Week (KBW) held in Aug 2022.  During his visit to Korea, Ethereum's last public testnet completed its merge, and Vitalik also conducted several interviews on Ethereum's scalability. 

Following the successful execution of the Goerli testate merge on Aug 11, 2022, the Merge has been formally scheduled to take place on Sep 10 - 20, 2022. With the Merge date just a few weeks away, this article will introduce  the Merge and explain how the upgrade will affect the crypto ecosystem. 

<Table of Content>

What is the Ethereum Merge?
- Background
- The Merge is the First Step of “Ethereum Phase 2”

Core Elements of Ethereum Merge
- The Beacon Chain
- Staking Deposit Contract

Ethereum Merge from an Investment Perspective
- Risks Involved in Ethereum Merge
- High Volatility Expected, Caution Advised

What is the Ethereum Merge?

1. Background

Ethereum had marked its intention to migrate from Proof-of-Work (PoW) to Proof-of-Stake (PoS) soon after its inception as PoW possessed clear limitations.

• PoW consumes so much energy, making it far less sustainable.
• PoW blockchains are harder to scale (traded scalability off for security).

Despite major criticisms, the Ethereum network launched the first PoW chain in Jul 2015. At the time, the launch of PoW instead of PoS was touted as affording the team more time to prepare to run a PoS chain while others believed it was decided by the Ethereum community that values “decentralization” as the most important philosophy. The reasoning behind choosing PoW is that in the PoS system, more substantial stakeholders end up with larger profit margins, causing centralization.

For the reasons above, Ethereum was launched as a PoW blockchain, but transitioning the network’s consensus mechanism to PoS was always in their plan. In fact, some of the early Ethereum developers left the network and founded Polkadot and Cardano, both of which run on the PoS blockchains. Casper (a mechanism that upgrades certain blocks to "finalized") is an implementation of PoS consensus algorithm in development for Ethereum. The name Casper was used by another blockchain project when launching its chain. Given the circumstances, it is not an exaggeration to say that Ethereum is the basis of most of today’s PoS chains.

Ethereum launched the Beacon Chain in Dec 2020 and introduced PoS to the Ethereum ecosystem. Though implemented, the chain does not directly participate in transactions on the Ethereum network, but some of the validators are currently testing the consensus algorithm and account balance.

However, the road to the Merge upgrade hasn’t been smooth sailing. In Mar 2022,  the last testnet merge took place on Kiln prior to the network's eventual move to a PoS network, though a problem occurred as it appeared that a client was not producing blocks consistently. As told by the Ethereum team, it turns out one block had the incorrect base value and substituting it with the correct value solved the problem. Then in Jun 2022, Ethereum core developers decided to delay the difficulty bomb and the news made the Ethereum community uneasy over concerns that the delay could affect the Merge upgrade once again. Despite the community’s concerns, all public testnets successfully switched to PoS, along with the third and final Goerli testnet completing its merge in Aug 2022.

After running a series of tests on numerous devnets and completing the merge on three public testnets, Ethereum selected the Terminal Total Difficulty (TTD, the cumulative difficulty threshold required of the final block mined in Ethereum). As the Merge happens with certain TTD, developers were able to predict when to expect the targeted TTD, and the predictions were that it would happen around Sep 10 – 20, 2022.

2. The Merge is the First Step of “Ethereum Phase 2”

After the switch to PoS, Ethereum will be able to provide the scalability that the network has long lacked, paving the road to mass adoption of crypto. This upgrade was previously called Ethereum 2.0, but the community moved away from the Ethereum 2.0 name to avoid confusion as it is no different from Ethereum 1.0. In this context, the term “phase 2” is used in this article when referring to the post-Merge state of Ethereum. Meanwhile, the Merge upgrade only includes the first step toward the PoS transition.

Interestingly, the Ethereum developers had sharding in the scope before the Merge upgrade. As securing better scalability has always been the issue throughout the development of Ethereum, the team’s focus was leaning toward handling more transactions by spreading the network load across multiple shards. Furthermore, having been running on PoW for too long, Ethereum’s maximum TPS remained highly limited compared to other L1 newcomers.

Sharding is a proposed solution for scaling Ethereum. The idea is to boost network efficiency by breaking up the main blockchain into separate segments (shards), so nodes only need to verify a subset of transactions. The below diagrams explain the sharding structure and how the database is partitioned into more manageable shards horizontally. For more details on sharding, please refer to the article previously published by Xangle.  

▶Xangle Research, <Sharding: The Future of Ethereum Blockchain>

On the other hand, considering that i) the development speed of the L2 solution was faster than expected and ii) the heavy burden of switching the consensus mechanism when the DeFi ecosystem was already growing too fast, the team decided that it was not worth to risk the network security over scalability. According to Ethereum developers, sharding will roll out after the mainnet integrates with the Beacon Chain.

The decision to postpone the implementation has put sharding on the back burner for the time being. Considering the slow progression of Layer 2 scaling solutions that are based on Optimism and Zero-Knowledge Proofs and the cross-shard communication issues, the move to PoS will open new opportunities to secure scalability.

For more details on Ethereum L2 solutions and other research articles on scaling technologies, please read the following.

 ▶Xangle Research, <Sharding: The Future of Ethereum Blockchain>

Core Elements of Ethereum Merge

The core elements of the Ethereum Merge upgrade are the following:
1) The Beacon Chain
2) Staking deposit contract

The Beacon Chain and staking deposit contracts play crucial roles in transitioning the consensus algorithm to PoS and increasing the number of validators to enable stable network operation. Let’s take a look at the significance of Merge from various perspectives.

• Ecosystem participants: The Merge upgrade itself will not change how the projects run their networks. But for some projects, the move to PoS could give rise to problems rather than bring benefits, meaning that they would have to pay extra attention to risk management. In the long term, the upgrade will lay the foundations for innovations that will boost scalability and speed with low fees, offering improved UX and UI altogether.

On the other hand, investors take on a slightly different view.

• Investors: The Ethereum Merge has great significance to crypto investors. It could be bullish for crypto investors because if the number of investors increases post Merge, the supply of ETH should decrease and in turn increase the value of individual coins, earning more interest. However, it is essential to consider how much the current ETH price reflects these implications. A conservative investment approach is recommended as the price is expected to be highly volatile before and after Merge. I will elaborate more on this point towards the end of this article.

In the next section, we will look into the Beacon Chain and staking deposit contracts to better understand the significance of Merge from various perspectives.

1) The Beacon Chain

The Beacon Chain is Ethereum’s PoS consensus layer that went live in Dec 2020. To increase the level of security on the Beacon Chain, the Altaire Beacon Chain upgrade went live in Oct 2021 to i) enable light clients and ii) increase penalties for node validator inactivity as development progressed towards the PoS transition.

<The Beacon Chain Timeline>

• Dec 2020: Ethereum releases the Beacon Chain
• Oct 2021: The Altair upgrade goes live
• Sep 2022 (TBD): The Merge upgrade

In the Beacon Chain, **Gasper** is the actual consensus protocol that secures the PoS chain. Gasper is the combination of i) LMD GHOST, a fork-choice rule that allows choosing among many forked chains, and ii) Casper FFG, an overlay atop a mechanism that marks certain blocks as finalized, providing safety.

1. LMD GHOST

To learn more about LMD GHOST, let’s get started with the GHOST protocol, which is the basis of LMD GHOST. GHOST (Greedy Heaviest Observed SubTree) protocol is a chain selection rule under which the heaviest chain is selected when there is a fork. According to this rule, “A” should be selected for the chain to generate blocks.

LMD is short for “Latest Message Driven.” LMD GHOST protocol chooses the side where more of the latest messages (attestations) support that block. The attestations should be based on the most recent messages. In the diagram below, the latest message from each vote is shown in blue. Following the LMD GHOST rule, parent block "A" wins as it has 3 children blocks supporting it versus 1 for "B."

2. Casper FFG

Casper the Friendly Finality Gadget (Casper FFG) is a PoS-based finality system. In Casper FFG, the genesis block is a checkpoint. When a checkpoint is “finalized,” the finalized block will not be reverted from the chain, preventing the protocol from malicious attacks. To finalize a checkpoint, it needs to get voted by more than 2/3 of the validators, and this rule is the core element of the technology. Two consecutive justified checkpoints are a condition for the former of them to be “finalized.” As mentioned previously, the rule is never to revert a finalized checkpoint, meaning that checkpoints function as safety measures that prevent transaction rollbacks.

3. Gasper

Gasper is a combination of LMD GHOST and Casper FFG and has added new concepts called a slot and epoch.

• Slot: A slot is a period of time in which a new block can be proposed by a validator. Each slot is 12 seconds. Occasionally, slots can be empty if no block is proposed by a validator during that slot. In this case, it will move on to the next slot.
• Epoch: An epoch is a period of 32 slots, each slot being 12 seconds, totaling 384 seconds (12 seconds x 32 slots).

A group of validators, called the committee, are assigned to validate blocks in each slot. A total of 32 validator committees are required in each epoch. In each slot, a single validator is selected from the committee to propose a block, and the rest validate the proposed block.

Slots and epochs are essential elements of the Beacon Chain for the following reasons. First, the block proposer of each slot uses the HLMD GHOST to decide which forked chain the block should be created to connect a slot to another. A security protocol that protects validators called HLMD GHOST is applied to the previously explained LMD GHOST.

Casper FFG creates the “Epoch Boundary Block (EBB),” which represents the checkpoint for a specific epoch. When these checkpoints are linked together, EBBs will count as finalized, meaning they cannot be reverted.

In Gasper, validators get rewarded for proposing and validating blocks while some validator actions that show malicious intent, such as contradicting previous checkpoint votes, are penalized.

We briefly looked into the main ingredients of the Beacon Chain. The complex architecture may be difficult to take it all in, but I hope the technical flow presented in this section helped underline the essentials of the protocol and understand the continuous research and development by Ethereum developers to bolster the stability and security of the network.

This article referred to several technical tutorials and articles. Check out the links below if you want to know more about the technology behind.

▶Vitalik Buterin, <A CBC Casper Tutorial> 
▶Vitalik Buterin, <Casper the Friendly Finality Gadget> 

How to Become a Validator on the Beacon Chain

To become a validator on the Beacon Chain, a minimum deposit of 32ETH stake is required. It is important to note that deposits are one-way with ETH unable to be withdrawn from the deposit contract. A validator’s effective balance is capped at 32ETH, meaning that when the actual balance rises above 32ETH, it does not get updated, and the validator incentive is also capped at 32ETH. Validators, each containing their stake of 32ETH, become part of the Beacon Chain’s validator group from which validators are randomly selected as block proposers or become part of the committee.

2) Staking Deposit Contract

Ethereum’s staking deposit contract is significant in that it is an essential component for the stable operation of PoS and an attractive option for investors.

<The Staking Deposit Contract Timeline>

• Oct 2020: Ethereum deploys the deposit contract
• ~ Sep 2022: Various Ethereum staking services to be launched across the DeFi ecosystem
• Sep 2022 (TBD): Merge upgrade
• Upcoming schedule (TBD): Shanghai upgrade (enabling ETH withdrawals on the Beacon Chain)

As mentioned in the previous section, depositing ETH in the deposit contract is a one-way, non-reversible process until withdrawals are enabled. Ethereum deployed the deposit contract in such a way as to ensure network stability, but there has been a heated discussion over this structure. Users had doubts about whether they will be able to afford the opportunity costs incurred by staking ETH. Another concerning point is the possibility of the network being unable to onboard enough number of validators, putting decentralization at risk and deteriorating network stability.

Contrary to the concern of some, 13.3M+ of ETH is staked on the Beacon Chain with over 400K active validators as of Aug 2022, demonstrating the stakeholder’s strong confidence in staking with Ethereum.

Other platforms suggest different approaches to addressing the concerns over Ethereum’s staking deposit contract. Decentralized protocols such as Lido, Rocketpool, and Consensys and Centralized exchanges such as Binance and Coinbase allow users to become validators with staking less than 32ETH by using pooling to transfer the liquidity. The solutions offered by various platforms are signaling that the transition to a fully decentralized PoS chain is just around the corner.

Experts who view the move to PoS will offer key benefits to Ethereum, and its investors say that ETH will become a more mature and productive cryptocurrency in Phase 2 for the following reasons:

• ETH holders can stake their assets to earn yield while contributing to network stability
• ETH may turn deflationary once gas fees start trending downwards, making block space more efficient (enabling a synergy with EIP 1559).
• It may also be further positioned as a store of value native to the Ethereum network

In its 2020 report on Ethereum 2.0, Messari described the Merge as a transition to staking tokenomics. Potentially, the shift to start allowing users to earn staking yields was seen as an additional upgrade to the nature of the asset. Messari writes in ETH 2.0: The Next Evolution of the Cryptoeconomy:

More holistically, PoS will make ETH a significantly more productive asset than it was under PoW. On the current PoW chain ETH possesses store of value and commodity properties from its use as money and gas. On the new Beacon Chain, ETH will also possess capital asset properties ... Recall that validators are required to stake 32 ETH as collateral to register their node on the network in order to participate in consensus. In this capacity ETH will function as a type of hybrid-perpetual bond with debt and equity like characteristics. In return for behaving honestly and securing the Ethereum blockchain, stakers will be rewarded a perpetual, though variable, ETH-denominated yield ... Although it is important to note that the payout of this yield will be deferred …

- Messari

 Arthur Hayes also wrote in "Five ducking digits" in Apr that the valuation of Ethereum could go to $10,000—so the five digits as the title goes—under assumption that Ethereum’s PoS transition could render ETH a hybrid perpetual bond.

Aside from the staking yields, the value of ETH is expected to rise after the PoS transition as: i) the supply diminishes, ii) EIP-1559 pushes up the burn rate, and iii) staking makes a dent in the circulating supply.

According to the project’s official announcement, ETH’s inflation rates on the execution layer (existing PoW chain) and the consensus layer (new PoS chain) as of Apr were 4.13% and 0.49% respectively. If 13M ETH is staked after the Merge, the inflation rate of the consensus layer will be maintained, allowing for a net reduction of 89.4% in annual issuance.

ConsenSys previously forecasted in a Messari report that the amount of ETH to be staked since the PoS transition would reach approximately 16M ETH before the first withdrawal available. Ultra Sound Money predicts that the daily issuance will stop at around 18,000 ETH if the amount staked is 16M ETH. Although the possibility of deflation will likely depend on the amount of burn, even under an assumption of zero burn, the amount still is a small fraction compared to ETH’s total supply of more than 120M.

Ethereum Merge from an Investment Perspective

1. Risks Involved in Ethereum Merge

It’s been a smooth sailing so far but risks remain. RBF Capital spelled out the following risks in its May publication, some of which are drawing a fresh attention lately.

1-1) Consensus Bug

The slimmest odds, but the biggest risk once it happens. The bug will bring chaos to the network and the cost of nullifying some of the contracts will be colossal.

1-2) Network Attack

Various types of network attack scenarios are another cause of concern. Even though Ethereum clients are more diversified than before and the dominance of Prysm has come down to 30% level, the network should be prepared not only for the 51% attack but also for unexpected attacks like the replay attack that took place at the time of the Ethereum Classic fork.

1-3) Delay in Ice Age Resulting in PoW Hardfork

Putting off the difficulty bomb, in itself, is not hard, but the longer the delay lasts, the easier the planning and execution of the PoW chain fork becomes. Chinese miners are mulling Ethereum PoW fork, which may cause a stir in the network.

Although the risk has not yet been completely resolved, anticipation is outrunning it on grounds of the long years of preparation and multiple stages of technological audit.

2. High Volatility Expected, Caution Advised

Aside from a possible nosedive from selling the news, some of the variables driving up the price of ETH seem to be misconceptions, adding to the risk of a volatile price swing.

2-1) The Much-Anticipated Cheaper Gas Fee

The Merge is a transition in the consensus mechanism—not an augmentation of network capacity, having no direct impact on the gas fee in itself. Even if the rollups that Ethereum’s post-Merge roadmap centers around may help reduce the gas fee in the long run, it seems that the misconception over the impact is partially reflected in the price already. (Please refer to the development surrounding the EIP-1559).

2-2) Anticipation for Higher TPS

Again, the impact is limited. Although it is true that the TPS of most PoS chains is higher than Ethereum, the speed slows as the number of validators grows when Ethereum already has more than 400,000+ validators. The level of anticipation for higher TPS is considered to require some adjustment, and a possible disappointment may result in a series of sell trades, stoking higher volatility.

Some may choose to seek a steady stream of yields from ETH staking on the PoS chain. But this also requires a conservative approach, given the opportunity cost of not being able to tap the funds until the Shanghai upgrade.

Conclusion

After all, the Ethereum Merge is only the beginning of a second phase into a colossal journey. Some, including L1 rivals, opine that the market is betting too high on the Merge. Still, it warrants attention though when the significance of the first-ever transition of a blockchain giant from PoW to PoS and the potential after a successful migration are considered—particularly at a time when the market is lacking momentum after the DeFi and NFT. So yes, there may be a spike in volatility calling for caution, but Ethereum’s post-Phase 2 future remains irresistibly intriguing regardless. I cautiously predict the Merge will likely act as a watershed that will make or break the potential of the blockchain and crypto industry to become an engine for a paradigm shift.

Other Related Research Articles

• [Xangle Valuation Series] ② Ethereum and Layer 1 
• Sharing: The Future of Ethereum Blockchain
• Ethereum Layer 2 Solution