September 2022

The Ethereum Merge

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This week, Ethereum will go through its largest upgrade ever. This event is known as “the Merge” and is the biggest technical event happening in crypto this year. This month we will dive into what the Merge is, how it is expected to take place and what the longer-term implications of the Merge are for Ethereum.

The Merge will complete the migration of Ethereum from “proof-of-work” to “proof-of-stake” consensus, which will reduce the chain’s processing power and energy requirements, making Ethereum more environmentally friendly. Longer term, this transition will bring about a range of scaling and security benefits. This month we will dive into what the Merge is, how it is expected to take place and what the longer-term implications of the Merge are for Ethereum.

When Ethereum launched in 2015, its key innovation was a new execution layer known as the Ethereum Virtual Machine (EVM). In Bitcoin, there is a stripped-down execution environment and limited scripting language that makes it very difficult to do anything other than send Bitcoin between accounts. In Ethereum, the EVM allows developers to write arbitrary code which has led to a flourishing ecosystem of developers and applications running on Ethereum.

While the EVM was novel and unique, the consensus algorithm that Ethereum used was the same proof-of-work consensus algorithm that is used by Bitcoin. As a quick reminder, consensus algorithms are mechanisms that enable nodes in a network to come to agreement as to what the state of the network is. Simply spoken, the proof-of-stake algorithm randomly picks a validator who is then tasked to validate transactions, in contrast, in the proof-of-work consensus algorithm, miners all compete to solve a very complex cryptographic challenge, the winner of this challenge gets rewarded to validate the block. Through this competing process, all proof-of-work miners perform computations in parallel, making it very energy inefficient. As a result, proof-of-work consensus requires a large amount of processing power to guarantee security. Even at the time of Ethereum’s launch, it was clear that this proof-of-work consensus algorithm would need to be updated. As early as 2016, initial designs for Ethereum 2.0 were being presented at Devcon 2 in Shanghai, as the core developers looked for ways to transition to proof-of-stake and improve on Ethereum’s 14 transactions per second.

From 2016 onwards, new smart contract platforms like Solana started releasing their designs and most of these platforms were using proof-of-stake consensus. Proof-of-stake requires validators to post collateral to guarantee security, making it less energy intensive, more environmentally friendly and with potential scalability and security improvements. It was clear that proof-of-stake would be the future underlying engine of smart contract platforms and that Ethereum would need to migrate to remain competitive.

The upgrade to Ethereum 2.0 has been a long time coming. In November 2019, we wrote about the design and phases of this upgrade, which was by that point already two years in the making. There are many intricate parts of this upgrade and some parts have already taken place. In December 2020, the “Beacon Chain” was deployed. This is a proof-of-stake chain that is the beating heart of Ethereum 2.0.

The Beacon Chain has several responsibilities:

  • Coordination: it stores and manages the registry of validators and coordinates the shard chains. In Ethereum 2.0 there will be 64 shard chains that each manage their own state but report to the Beacon Chain.
  • Nomination: it nominates the chosen block proposer for each shard on Ethereum and organises validators into committees to vote on proposed blocks.
  • Rewards: it rewards or penalises validators based on their actions (good validators receive block rewards and malicious validators are slashed).
  • Anchor: it is the anchor point where shards register their states, allowing cross-shard transactions to take place.

While the Beacon Chain has been operational for almost 2 years, it has not been processing transactions. During this time, there have been two Ethereum chains operating in parallel. What is happening this month is that the two chains are being combined, with the current Ethereum main chain merging with the Beacon Chain, hence the term “the Merge”.

The process of the Merge is a complicated one that will (hopefully) only ever happen once. There is not a set date for the Merge, but instead the Merge will take place when the target Terminal Total Difficulty (TTD) reaches 58750000000000. Every block that is mined on Ethereum has a level of difficulty that is going up. Once this specified TTD is reached, the Merge will be activated. As of today, the estimated time of the Merge is 15th September 2022 at 6am UTC. A countdown can be seen here.

Numerous tests have been completed of the Merge on various Ethereum testnets, and the core developers of Ethereum seem confident that the Merge will go through as intended. However, there are several risks and attacks that users will need to watch out for.

From short to longer term, some risks include:

  • 12-minute chaos: the Merge itself will take 12 minutes to complete. Exchanges are pausing deposits and withdrawals during the process, and it is highly advisable not to make any on-chain transactions during these 12 minutes. This is when bugs or transition issues are most likely to surface, which could impact contracts and transactions.
  • Replay attacks: after the Merge, proof-of-work miners will effectively be out of business. It is extremely likely that some miners will continue to mine the proof-of-work chain meaning that there will be a fork of Ethereum. Digital assets on Ethereum will be duplicated on both the new Ethereum 2.0 chain and on the old, deprecated proof-of-work chain. After the Merge, a user that sells their proof-of-work chain assets (potentially at a heavy discount) could find that whoever they sell to may also replicate the transaction signature on the new proof-of-stake chain to also get hold of the more valuable version on the proof-of-stake chain. To mitigate these attacks, proof-of-work forks of Ethereum need to change chain IDs to make them different from the new proof-of-stake chain. A number of proof-of-work Ethereum forks have already committed to doing this.
  • Censorship: the new chain may be more susceptible to government censorship. The Beacon Chain currently has four validators that make up over 60% of the network. Two of these validators, Kraken and Coinbase, are both US based companies that may be required to adhere to government rulings to censor addresses or contracts on Ethereum. This potential issue has recently come into focus following the U.S. Treasury Department sanctioning of Tornado Cash.

There are risks surrounding the Merge, but the upside of this upgrade far outweighs the risks.

In the immediate term, from a user experience perspective, the Merge will have very little impact. Transaction fees will remain the same and transaction times will decrease only slightly, with block times shortening from about 14 seconds to 12 seconds. Longer term, the Merge sets the course for how Ethereum will scale and has several benefits.

  • Energy efficiency: from the moment the Merge takes place, Ethereum’s energy consumption will fall 99.95% according to the Ethereum Foundation. Existing proof-of-work Ethereum miners will be replaced by validator nodes that do not need to compete on processing power, leading to a far greener network.
  • ETH issuance: the issuance of new ETH will fall 90% as soon as the Merge takes place. Proof-of-work mining rewards are currently around 13,000 ETH per day and will immediately cease. New issuance that will remain is the 1,600 ETH going to validators. There is also the possibility that ETH becomes deflationary after the Merge as a portion of gas fees are burned in every block, offsetting the new issuance.
  • Scalability: the Merge is part of Ethereum’s scalability roadmap and will make sharding possible. Sharding is where a network is divided into many “shards” that can process transactions in parallel. The plan is for Ethereum to eventually have 64 shards, which will lead to huge scaling benefits. Coordination for these shards is done through the Beacon Chain.

From a technical perspective, the Merge is clearly required and has been a long time coming. At CMCC Global, we are excited by Ethereum’s technical roadmap and look forward to its more environmentally friendly proof-of-stake future. Ethereum is on a path to scalability, although it is not yet clear whether roll-ups on the Ethereum mainchain will be more impactful than sharding. The Merge allows both to co-exist and we will closely monitor developments between Layer-2 solutions and the longer-term deployment of shards.

From a price perspective, we are expecting short term volatility and long-term appreciation for ETH. The Merge has been telegraphed for many months and it has become the primary trading narrative for Ethereum. There is a risk that traders will “sell the news” leading to downward price pressure in the coming weeks. However, longer term, the structural change in ETH issuance, coupled with the incentive for users to stake (and lock up) ETH to earn yield, makes price appreciation likely. There will be 13,000 ETH less a day being created and given to miners, who are net sellers of ETH. We anticipate that this reduced selling pressure will impact market dynamics, pushing the price of ETH higher.

With the Merge (hopefully) completed this week, the natural question will be as to what is next for Ethereum. At a recent conference, Vitalik Buterin laid out further upgrades for Ethereum. He claims that Ethereum will only be 55% complete after the Merge and the target for Ethereum is to get to 100,000 transactions per second. To achieve this, Ethereum will need to go through what he calls the “surge,” “verge,” “purge,” and “splurge.” So fear not. There is still plenty for us to write about going forward!