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What is The Merge?

A Step-by-Step Guide to Ethereum’s Historic Upgrade

What is The Merge?

In 2014, Ethereum launched Beacon Chain, a Proof-of-Stake (PoS) network that differed from the original. Up until that time, Ethereum has used the same type of consensus mechanism to maintain its blockchain as Bitcoin — Proof-of-Work. Beacon introduced a new way to add blocks of data to the chain — staking.

From Sept. 15 to 16 2022, Ethereum will become a PoS network when Beacon merges with its mainnet. The move will ditch miners and computational work in favor of economic staking and validators. Here’s a primer explaining what this means for decentralized finance:

Why Is Ethereum Important?

While Bitcoin legitimized the concept of peer-to-peer (P2P) digital money, it was Ethereum that spearheaded the blockchain’s next move — smart contracts that deploy decentralized applications (dApps). Bitcoin accounts for about 40% of the total market capitalization in crypto. Ethereum broadened smart contracts for many uses — borrowing, lending, predictive markets, NFT marketplaces, exchanges, gaming, governance, wallets, storage, and even gambling. 

The total value locked in Ethereum multiplied almost 12-fold, to $110.6B, between Nov. 2020 and Nov. 2021. Clearly, dApps were in high demand.

This surge strained Ethereum’s capacity.

Ethereum’s Proof-of-Work Scalability Problem

Both Bitcoin and Ethereum launched as PoW systems that added new data blocks to a blockchain through costly computational work. 

Under PoW, blockchain networks are less vulnerable to  hackers. The consensus mechanism also uses enormous amounts of electricity because miners race to solve mathematical problems first and win the right to add blocks to the chain. That means employing vast server farms. Yet PoW has demonstrated that blockchains can be immutable. Without this immutability, Bitcoin would not have been tenable and it would have been worthless.

The difference between Bitcoin and Ethereum’s utility is clearly visible when we compare their daily transactions. Despite having twice as much market cap as Ethereum, Bitcoin has over five times the lower number of transactions.

Source: The Block

Yet  if Ethereum is to go mass market its energy expenditure would become impractical. This is the primary reason why Ethereum is transitioning from PoW to PoS.

By making this shift, Ethereum Foundation estimates that the network’s energy footprint will decrease by ~99.95%. There are plenty of other benefits, too.

What Exactly Is The Merge?

In December 2020, Ethereum launched  Beacon Chain.

Source: Beaconcha.in

Beacon operated like other PoS networks, such as Algorand, Avalanche, Cardano, or Solana. Validators run software that turns their computers into blockchain network nodes. Each node is in charge of storing the entire ledger copy, processing transactions, and adding them to the blockchain.

In exchange, validators receive ETH rewards. Unlike Bitcoin’s miners, validators use a fraction of the energy to execute and add new data blocks. When it comes to the validator requirement, a common misconception is that they need 32 ETH as the minimum stake.

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This only applies to nodes that propose the next blocks to be added. The majority of Ethereum validators run non-block-generating nodes, through pooled staking. Vitalik Buterin explicitly stated that a low barrier to entry is key to keep Ethereum decentralized. After all, the more nodes there are, with each containing ledger’s full copy, the greater the redundancy.

Expected Impacts of the Merge

There is confusion about what will and won’t happen after The Merge. Here are some of the most common misconceptions:

Will ETH Gas Fees Go Down?

Contrary to popular belief, The Merge will not significantly affect ETH gas fees. Whenever a network’s traffic load is high, the fees increase because there are only so many transactions the Ethereum network can process. Because The Merge is not focused on scalability, but on staking itself, this will not change.

At the moment, Ethereum can process up to 15 transactions per second (tps). This will not significantly change post-Merge. At best, there could be a single-digit percentage increase in tps due to lowered block times, from 13.3 seconds to 12 seconds.

An average block time is the time it takes to add a new data block (transaction) to the blockchain. For a more significant tps increase to happen, Ethereum must undergo sharding, which is the next scheduled upgrade, called The Surge, sometime in late 2023 or 2024.

Sharding will break up the network into pieces, so the network load is spread out more evenly. In the meantime, Ethereum will rely on Layer 2 scalability networks such as Polygon, Optimism, Arbitrum, and others for a low gas fee experience.

What About Staking Rewards?

All the validators, who have staked (locked) their ETH in Beacon Chain, will have to wait a bit longer after The Merge to withdraw the funds. Specifically, this will happen after the Shanghai upgrade, which is scheduled to commence about a year after The Merge.

In addition to unlocking the staked ETH by activating EIP-4895, Shanghai upgrade will introduce a new type of smart contract called EVM Object Format (EOF). It will further expand Ethereum’s smart contract functionality.

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Moreover, those validators running block-proposing nodes will only be allowed to partially withdraw their staked ETH, leaving behind the 32 ETH minimum required. Naturally, this limit was put to prevent a mass exodus of validators. Otherwise, the network’s security would come under risk.

Lastly, because validators are more efficient in processing transactions, the annual percentage rate (APR) is likely to increase from ~4% to ~7%. Receiving native token rewards for validating transactions is at the core of every decentralized blockchain network. On one end, traders pay transfer fees, and on the other end, validators receive them.

This way, there is no need for an accounting department, as this incentive structure is automated through smart contracts.Of course, the more users become active, the more fees validators receive.

ETH Tokenomics Shift

Another important aspect of The Merge is how it will change the ETH inflation rate. Each blockchain network has its own inflation control mechanism. For example, Bitcoin has halving events that reduce mining rewards, which means that fewer bitcoins are released into the circulating supply. Since its launch, Bitcoin had three halvings, going from 50 BTC mining rewards to 6.25 BTC.

With less inflow of new Bitcoins, each one appreciates more due to the law of supply and demand. In the case of Ethereum, it doesn’t have a limited coin supply like Bitcoin or even other PoS networks like Avalanche.

Instead, Ethereum has an inflation rate of about 13,400 ETH or 4.2%.

Source: EtherScan.io

Post-Merge, the ETH issuance should go down to ~0.2%, which is equivalent to Bitcoin’s “triple-halving.” Combined with the anti-inflationary pressure coming from burning base fees (introduced with EIP-1559), this translates to greatly increased demand over supply. As of August 2022, $4.7 billion worth of ETH has been burned, i.e., sent to a dead wallet. 

The top represents Ethereum’s pre-Merge tokenomics, while the bottom simulates its post-Merge tokenomics. Source: ultrasound.money

The reason for Ethereum’s lower inflation rate is directly tied to greater PoS energy efficiency. Accordingly, validators will need less ETH rewards post-Merge. Overall, having an inflation rate under 1% should positively impact ETH price, especially if greater utility is added into the mix. In conclusion, The Merge should result in the following impact on ETH price:

More utility + lowered ETH issuance + burning = greater demand → higher ETH price.

What After The Merge?

One could make the argument that Ethereum is already lagging behind other PoS blockchains. While none have Ethereum’s dApp offering, Solana, Avalanche, Tron, and Algorand provide users with Visa-level transaction speeds and negligible fees.

With The Merge completing on 16 Sep. 2022, this means that Ethereum is just starting to approach its performance. Keep in mind that Vitalik Buterin placed just a 55% upgrade completion figure after the Merge. More upgrades will be needed to call it fully ETH 2.0:

  • The Surge – scaling up Ethereum’s mainchain through sharding. This should increase the network’s throughput up to a theoretical 100,000 tps.
  • The Verge – upgrading Merkle trees with experimental Verkle trees for greater storage efficiency within each data block.
  • The Purge – purging excess historic data that is no longer needed, so validators can become even more efficient in processing transactions.
  • The Splurge – the maintenance era of the Ethereum network, tweaking and adding minor life-quality improvements. 

In the end, this long roadmap gives Ethereum competitors plenty of room to take DeFi’s market share. Only time will tell if Ethereum’s first mover advantage will have such sustaining power. 

Series Disclaimer:

This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.

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