Ethereum is the leading smart contract platform. The project is approaching the most important update in its history, called The Merge. It means abandoning the current Proof of Work consensus protocol and moving to the Proof of Stake consensus. The end result is also commonly referred to as Ethereum 2.0. This article reviews the history, technology, and impact of Ethereum 2.0 updates on the future of Ethereum.
Note: We use the term Ethereum 2.0 in this article, even though it is desired to get rid of the term in the official documentation. Ethereum 2.0 has been in use for years and is also a great description of the new Ethereum system. In this article, Ethereum 2.0 refers to Ethereum with the Proof of Stake consensus, while the 1.0 version is the current Proof of Work system.
The background of Ethereum 2.0
Let’s start with the background of Ethereum 2.0. Why do we need a new version at all?
Ethereum originated from a white paper described by Vitalik Buterin in late 2013. The project was launched in 2014 by Buterin, Charles Hoskinson (founder of Cardano), Gavin Wood (founder of Polkadot), and half a dozen other key people. Over the years, Vitalik Buterin has become the public face of Ethereum.
If you’re not familiar with Ethereum, check out our beginner’s guide. This article does not go into the basics.
The Ethereum blockchain was launched on the 30th of July 2015. This initiated a long series of updates and hard forks that have been steps towards Ethereum 2.0. The most famous hard forks are Homestead (3/2016), Byzantium (10/2017), Constantinopole (2/2019), and Istanbul (12/2019). We will look at 2020-2021 in detail later in this article.
Image credit: History of Ethereum Hard Forks
The vision of Ethereum 2.0 has existed since the early days of the project. The Proof of Stake consensus was discussed even before the launch of the Ethereum blockchain. Differences of opinion on the roadmap led to the resignation of Charles Hoskinson and Gavin Wood among others.
Ethereum 2.0 has become a hot topic in recent years. A couple of dozen solid smart contract platforms have entered the market, with much higher transaction capacity. Ethereum is now the only major Proof of Work platform. This technology has limited its growth and multiplied transaction fees, driving small investors to competing platforms.
The move to a Proof of Stake consensus will allow scaling up to 100x the capacity of today’s system. In addition, Ethereum will also be scaled with Layer 2 solutions (Arbitrum, Optimism) and sidechains (Polygon). The future of Ethereum depends on the successful implementation of version 2.0. The system needs to scale as quickly as possible or there will be an overflow of developers to competing platforms.
Ethereum’s market share in the DeFi sector is currently (4/2022) around 54%. In January 2021, the figure was as high as 94%. It was still over 70% in August 2021. This is a clear indication of the increased competition in the smart contract platform sector.
Let’s look at the milestones of Ethereum 2.0 and the events of 2021 that will set the stage for future updates.
Beacon Chain and staking
The first concrete step towards Ethereum 2.0 was taken in November 2020. This was the launch of the Ethereum 2.0 deposit contract, a smart contract that required investors to stake around 525,000 ETH tokens by 24 November 2020. If not enough people had joined, the launch of 2.0 would have been delayed.
The required number was filled on the last day. As a result, the Ethereum 2.0 blockchain was launched as planned on December 1st of 2020. Vitalik Buterin tweeted about the Genesis blockchain as follows.
Normal people: we should really put something profound in the first block of the ethereum PoS chain, something about giant leaps for mankind or whatever.
Ethereum community: pic.twitter.com/cOu94fUPE9
— vitalik.eth (@VitalikButerin) December 1, 2020
The blockchain is called Beacon Chain. It is a blockchain using the Proof of Stake consensus, which has been running alongside the current Proof of Work blockchain. No applications or other functionality exists in the Beacon Chain besides staking.
The Beacon Chain is maintained by validators instead of miners. Anyone can become a validator by locking 32 ETH into the deposit contract, which is equivalent to about $106,000 at today’s price. At the launch of the Beacon Chain, Ethereum was trading at $590. At that time, you could have become a validator for less than $19,000.
Despite its limitations, Beacon Chain staking has been hugely popular. Every ETH staked in the Beacon Chain is locked (can’t be withdrawn) until the Ethereum 2.0 version is finalized. This has not been an issue for investors.
More than 11 million ETH is locked in Beacon Chain with a total value of $37.4 billion. There are more than 334,000 validators. The annual interest rate for stakers is currently 4.6%. You can check out the latest statistics and find out more about staking on Ethereum’s Launchpad.
The Beacon Chain has been operating without any issues. Its popularity has also grown steadily. This has given investors confidence that future Ethereum 2.0 steps will be successfully completed.
London hard fork and the EIP-1559 update
Once the Beacon Chain was launched, the discussion moved on to the next update: EIP-1559. This was a really hot topic throughout the year 2021.
The EIP-1559 process began in 2019. The man behind the suggestion was none other than Vitalik Buterin. EIP-1559 was activated in August 2021 together with the London hard fork. At the same time, a couple of less significant upgrades were also carried out.
The EIP-1559 update changed the structure of Ethereum transaction fees. High volatility had long been a problem, forcing users to pay excessive gas fees when making transactions. EIP-1559 brought predictability to this. The most significant change, however, was the partial burning of transaction fees.
From August 2021, the so-called base fee has been abolished. Only an optional tip has been paid for miners, which can still be used if someone wishes to get their own transactions first in the queue.
The Ethereum blockchain has had deflationary days and even deflationary weeks since the EIP-1559 was launched. This means that more ether has been burned than issued to the market through block rewards (inflation).
The image below is taken from watchtheburn.com at the time of writing.
Almost 3.3 million coins have been burned in six months, worth almost seven billion dollars! All this ETH is off the market. The effect, measured in percentages, has been over 63% reduction in inflation.
The EIP-1559 update had a significant impact on the attractiveness of Ethereum as an investment. It will continue to burn tokens in the same way even after the Proof of Stake launch.
A smaller-scale Altair hard fork was also carried out in October 2021. This was an upgrade specifically for the Beacon Chain. It prepared the Proof of Stake blockchain for the upcoming The Merge update, which will be discussed next.
The Merge update
Let’s move on to the future. The next step is called The Merge. The name itself gives a good idea of what it’s all about. The Merge update combines the current Ethereum blockchain and the Beacon Chain.
The graphic below illustrates this well. It also shows the previously described updates Beacon Chain, EIP-1559, and Altair.
The most significant change is that the Proof of Work consensus algorithm is being phased out. What will happen to all Ethereum miners after The Merge? It’s hard to say yet.
In this context, the developers of Ethereum want to abandon the term Ethereum 2.0. It has been perceived as causing unnecessary confusion, especially among new investors. Moreover, the 2.0 version may attract a lot of scammers at the time of the happening, scaring users into transferring their tokens to the “new version” at the risk of losing them.
As stated at the beginning, we use the name Ethereum 2.0 in this article to illustrate the new entity, as there is currently no better name available.
After The Merge, Ethereum will be a two-tier architecture:
- Ethereum 1.0 → execution layer
- Ethereum 2.0 → consensus layer
- Execution layer + consensus layer → the new Ethereum (“Ethereum 2.0”)
The Proof of Work consensus is removed from the current ecosystem leaving just the execution layer. This is where smart contracts and transactions are processed. The Beacon Chain takes over as the new consensus layer. This is where the validation and staking take place. These two form the new Ethereum, which many now call Ethereum 2.0.
At the time of writing, the schedule for The Merge has not yet been finalized. It is likely to be late summer, for example, July-August 2022. We will report on this in more detail as it gets closer. The latest step in the preparation of The Merge was the update of the Kiln test network in mid-March.
Update 4/13: Ethereum developer Tim Beiko estimated that the Merge will take place “a few months after June”.
Impacts of The Merge
Let’s now look at the impacts of The Merge. There are a lot of different rumors about this. The biggest misunderstanding is about scalability. Unfortunately, The Merge does not yet solve Ethereum’s scalability issues.
We recommend watching the Coin Bureau video below, starting at 6:01, for a comprehensive discussion of the implications. The video should automatically start at the correct point.
An everyday user is unlikely to see any differences after the Merge. This is an update to the consensus layer. The execution layer doesn’t change. It means that smart contracts and transactions are processed the same way as before. The block time also remains at ~12 seconds.
The move to the Proof of Stake consensus will allow Ethereum to scale to a whole new level. However, it will require further upgrades, which will not be ready until 2023. This means sharding. The Merge lays the framework for this.
The short-term impacts will be felt by Ethereum investors. One important thing is ESG, which stands for Environmental, Social & Governance. A growing number of investors are taking ESG into account when making investment decisions.
In practice, this means investing in companies that are concerned about the environmental impact, social responsibility and good governance principles. The growing popularity of ESG has led to an attack on Proof of Work cryptocurrencies also at the EU level. When Ethereum moves away from the Proof of Work, its energy consumption will drop by 99.9% from the current level.
However, the biggest impact of The Merge can be seen in inflation. This is where the term ultrasound money comes into play.
So far, around 5.4 million ETH per year has been issued to the market. This is expected to drop by 90% after The Merge. Inflation will fall from around 4.3% to just 0.4%. This is a very low figure, as Bitcoin’s annual inflation rate is 1.7% by comparison.
And that’s not all. The figures above do not take into account the impact of EIP-1559. When you add in the EIP-1559, Ethereum becomes a deflationary currency. Its inflation is estimated to drop to -0.5% after The Merge.
You can simulate different outcomes yourself at ultrasound.money.
The third effect is likely to be seen in the staking. The locking up of assets in the Beacon Chain has kept many institutional investors away from Ethereum staking. After The Merge, the problem no longer exists. This is likely to increase the number of validators, which locks even more ETH out of the market.
However, The Merge will not release staked funds immediately. This will happen after a new update in about six months. Therefore, we will have a situation after The Merge where no ETH will be issued on the market for six months. If, at the same time, the popularity of staking increases, the result could be a gigantic supply shock.
One more important point. The yield on staking is also expected to rise from 5% to as much as 10-15%. We are looking at increasing demand combined with dramatically lower inflation. Not a bad combination for investors.
Sharding and Layer 2 solutions
The Merge is a really big update to Ethereum, but the 2.0 concept is not yet complete. As mentioned above, The Merge does not yet solve the biggest problem in Ethereum. High transaction fees and limited capacity will be present for some time.
Ethereum 2.0 is completed with sharding. The term may be familiar to some readers from the world of databases. Sharding allows data processing to be broken down into smaller fragments, which can be processed simultaneously.
The architecture of Ethereum will eventually look like this (image credit)
Even sharding alone does not put Ethereum on par with the fastest blockchains. The final stage will see the Ethereum scale with sharding and Layer 2 solutions & sidechains.
Layer 2 solutions can be compared to the Bitcoin lightning network. They are compatible with the Ethereum processing layer, allowing Ethereum dapps to be easily cloned to Layer 2. Curve and Uniswap are examples of popular DeFi apps currently scaled to Arbitrum. Sidechains and Layer 2s also leverage the security of the Ethereum network.
Ethereum’s scaling solutions have gained significant popularity in 2022. They have already saved users up to billions of dollars in transaction fees.
The Merge is arguably the most significant update to Ethereum. The move from the Proof of Work consensus to Proof of Stake is a really big deal. It will condense years of work while taking an important step towards a scalable Ethereum.
The Merge is likely to cause a huge stir in the weeks and months before it. The already mentioned EIP-1559 was the number one topic of discussion for weeks, even months. Investors need to be careful now, as The Merge is likely to be marketed with incorrect facts. This was also the case with EIP-1559.
The upcoming update will not yet solve Ethereum’s scaling problems. Neither will it reduce transaction fees. Scalability will only be achieved through future updates and Layer 2 solutions. This is important to keep in mind.
However, there is no reason to underestimate the impact of The Merge on investors. Increased staking yields combined with deflationary pressure – what more could you ask? It is hard to believe that the market could price in the impacts of these.
In the light of current data, it seems that the attractiveness of Ethereum as an investment will continue to improve. If you want to invest in Ethereum, we recommend buying it from Binance.