The Ethereum Merge Explained

An exploration of the Ethereum Merge & what it means for crypto’s largest ecosystem moving forward.

Since April 2022, Ethereum has been running two parallel blockchains. One of them is the existing execution layer of Ethereum, which is the mainnet we currently use and operates using proof-of-work. The other is the consensus layer, the new Beacon Chain, which uses proof-of-stake. The Merge will combine these layers into one unified blockchain. The estimated Merge date is the 19th of September 2022, according to ‘Consensus layer Call 91 #566’.

The Merge is expected to make the Ethereum network more efficient, sustainable and scalable.

  • The Merge will reduce Ethereum’s energy consumption by 99.95%, making Ethereum more environmentally friendly. (Efficient, Sustainable)
  • The Merge sets the stage for future scaling upgrades, including sharding. (Scalable)

How does this affect ETH?

  • Consensus mechanism: change from PoW to PoS.
  • Participants need to stake 32 ETH to activate validator software.
  • Participants will be incentivised to act honestly since their staked ETH can be destroyed (slashed) if their actions are misaligned.
  • Potentially more decentralised since the Merge makes Ethereum easier for the average participant to secure the network.

Decentralisation:

  • PoS does not necessarily make Ethereum more decentralised.
  • Participants with many tokens could also lead to a centralisation problem.
  • The top 4 Ethereum stakers are responsible for more than 50% of staked ETH. Lido Finance is responsible for 33% of staked ETH as displayed in figure 2.
Figure 2: Beacon Chain Depositors (Source: CoinDesk Research, Nansen, Etherscan)

ETH Supply

ETH Supply = Current Circulating Supply + Issuance of ETH — Burned ETH

Figure 3: ETH Pre & Post-Merge Changes (Source: Ethereum.org)

The amount of burned ETH will also depend on the volume of activity. When there is a significant increase in transaction volume, ETH may become even more deflationary and vice versa.

Figure 4: Ethereum Staking (Source: Ethereum.org)

Staked ETH is increasing 7% on average each month.

According to Ethereum’s official website, staking APR is expected to grow 50% from the current 4.2% to ~7%.

This is a result of the reallocation of transaction fees that begins going to validators instead of miners. However, the final staking APR is expected to be lower than 7% due to:

  • Ethereum is a blue chip asset in the cryptocurrency market. Its staking APR will likely be treated as a ‘low-risk rate’ across the cryptocurrency universe.
  • It will attract more institutional investors seeking relatively safe and stable returns to buy and stake ETH.
  • The percentage of staked ETH is only 11% compared to that of Solana (77.1%), Cardano (53.6%) and Polygon (34%), and is anticipated to grow to another 20–30%, ultimately lowering the staking APR.

After the Merge, all validators will be incentivised to withdraw their staking balances above 32 ETH as it will not generate extra yield. However, this does not directly infer that there will be sizeable unstaking pressure primarily because;

  • Shanghai Upgrade — staked ETH and newly issued ETH will remain locked and illiquid for at least 6–12 months following the Merge.
  • The withdrawal limit is 43,200 ETH per day.
  • It will take more than one year to withdraw all staked ETH.
  • As some validators unstake their ETH, potential returns will increase and simultaneously attract more participants to stake.
  • For pooled staking (e.g. Lido Finance), their users can ‘unstake’ anytime since there is currently enough liquidity to sell their stETH for ETH on Curve.
Figure 5: stETH on Curve (Source: Curve Finance)
  • The figure below also displays that the demand for stETH is increasing by monitoring its price. The price of stETH relative to ETH increased from 0.94 in June to 0.97 toward the end of July. (Currently, there is 4.13 million ETH staked with Lido, comprising 31% of the market share)
Figure 6: stETH Peg (Source: TradingView: UniSwap)
  • The figure below displays that most stakers on Lido are likely to be retail investors since the median deposited value is between $2048 & $4095. Approximately 84% of deposits are below $32,000 in value.
Figure 7: Distribution of Lido Deposits (Source: Dune Analytics)

Gas Fees

  • Gas fees are a product of network demand relative to the network’s capacity.
  • The Merge will not result in an expansion of network capacity or activity. Therefore, the Merge will not directly result in higher or lower gas fees.

Transactions per second (TPS)

  • Under PoW, the target was to create a new block every 13.3 seconds.
  • Under PoS, slots occur every 12 seconds (each slot is an opportunity for a validator to publish a block).
  • The improvement in speed is less than 10% which is unlikely to be noticed by users.

Risks

  • Since the Merge is the change of Ethereum’s consensus mechanism, it may cause the supporters of PoW to leave Ethereum.
  • PoS may make Ethereum more centralised, and Lido Finance is already responsible for 32% of the staked ETH.
  • The Merge could get delayed again.

To conclude, the Ethereum Merge will change the way its ecosystem & larger crypto markets develop moving forward. Whether it’s worth compromising the idea of decentralisation for scalability will be answered in due time.

REFERENCES

Cardano Staking. (n.d.). Staked. https://staking.staked.us/cardano-staking

Curve.fi. (n.d.). Curve Finance. https://curve.fi/steth

Ethereum Foundation. (2022, July 14). Consensus Layer Call #91 [2022/7/14] [Video]. YouTube. https://www.youtube.com/watch?v=yBEPzzeo1a4

Ethereum Foundation. (2022b, July 26). How The Merge impacts ETH supply. Ethereum.Org. https://ethereum.org/en/upgrades/merge/issuance/

Ethereum Foundation. (2022b, July 26). The Merge. Ethereum.Org. https://ethereum.org/en/upgrades/merge/

Lido Deposits Value Distribution. (n.d.). Dune. https://dune.com/queries/20044/41192

Matic Network Staking. (n.d.). Staked. https://staking.staked.us/matic-staking

Solana Staking. (n.d.). Staked. https://staking.staked.us/solana-staking

TradingView. (n.d.). Liquid staked Ether 2.0 / Wrapped Ether. https://www.tradingview.com/chart/?symbol=UNISWAP%3ASTETHWETH

Watch The Burn: EIP-1559 Real-Time ETH Burn Visualization for Ethereum. (n.d.). Watch the Burn. https://watchtheburn.com/

Young, S. D. (2022, May 18). Will a Proof-of-Stake Ethereum Lead to More Centralization? CoinDesk. https://www.coindesk.com/layer2/2022/05/18/will-a-proof-of-stake-ethereum-lead-to-more-centralization/

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Greythorn Asset Management

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