A comprehensive analysis of the impact of the Ethereum network's "double upgrade" on withdrawals and ETH supply

Since December 2020, Ethereum network validators have voluntarily locked their ETH on the Beacon chain, and there is no clear timeline for the withdrawal function.

The upcoming Shanghai-Capella “double upgrade” will mark the end of this era, granting validators access to staked ETH while also providing rewards for validation. In this article, we will explore the impact of the upcoming Ethereum network “double upgrade” on withdrawals and ETH supply.

Ethereum "double upgrade"

The upcoming upgrade of the Ethereum network protocol is actually a "double upgrade" (Shanghai and Capella). They are upgrades to the part of the Ethereum network that performs calculations and transactions (the execution chain) and the part that controls the production and verification of new blocks (the Beacon chain). The execution chain refers to the part of the network that handles consensus (through mining) and execution (updating balances, changing the internal state of smart contracts) before the Merge.

The Shanghai upgrade is a hard fork of the network's execution layer (i.e., the execution chain) that aims to implement a series of changes to some operations of the Ethereum network. Its most important upgrade will allow validators to withdraw their ETH for the first time since the beacon chain was established in December 2020. When the network switches from proof-of-work ( PoW ) mining to using the Beacon chain to control block production in September 2022, the Ethereum Foundation has set a tentative deadline to activate the withdrawal function in the next network upgrade.

Recently, the “double upgrade” timeline was brought forward to March 2023, and is currently awaiting the completion of several successful tests. The Ethereum Foundation has recently been working hard to achieve this goal within the originally promised time frame, and has even postponed other upgrades originally scheduled to be deployed in Shanghai in order to prioritize the launch of the coin withdrawal function.

Note that validators can currently suspend their validation duties and “unstake” their ETH without withdrawing it. The Shanghai upgrade will allow withdrawable users to withdraw their ETH from the Beacon chain.

How the upgrade will be implemented

Like previous network upgrades such as Merge or the London upgrade, the Shanghai upgrade will be done using a hard fork. This requires every node listening or validating on the network to install a new version of the Ethereum network client. A client refers to a program that each node runs locally in order to interact with the rest of the network. There are multiple versions of the Ethereum client, released by different third-party providers, but each version promises to implement the provisions of the open source Ethereum protocol decided by the Ethereum Foundation.

Once the Ethereum Foundation finalizes the upgraded protocol, each client provider will release an upgraded version of their client that contains both the old and new versions of the protocol. For all blocks after the agreed block height (the length of the blockchain from one block to the first block on the chain), every node on the network will start using the upgraded version of the protocol. This ensures that the original history of the network will remain unchanged. Since the upgraded protocol will only apply to blocks with a block height higher than the agreed number of blocks, if the chain is restored to a block before the switch, the node will use the previous version of the rules. This ensures that the network reaches a consensus when the new rules apply.

test

In preparation for the upgrade to the network, the Ethereum Foundation has created a copy of the Ethereum network for testing its changes. This is achieved by configuring a small group of nodes (validator nodes and non-validator nodes). This sidechain allows developers to simulate network upgrades on a separate chain and fix any bugs they encounter. This process is called a shadow fork.

By shadow-forking the Ethereum mainchain, developers have launched a series of public testnets for developers to test their smart contracts on the proposed version of the network. The first public testnet, Shandong, was launched on October 14, 2022, launching 5 planned upgrades, but not the withdrawal function of the Beacon chain. The Zhejiang testnet, launched on February 1, allows developers to test all proposals (EIPs) included in the Shanghai-Capella "double upgrade". This includes a simulation of a hard fork that will switch nodes from the current version of the Ethereum protocol to the upgraded version. After the hard fork on the testnet, users will be able to test the withdrawal process using ETH on the test chain, but will not be able to communicate with the Ethereum network in real time.

Staking process

Users can stake ETH on the Beacon chain to validate new blocks and contribute to the security of the blockchain. In return, stakers receive rewards when they complete their work “correctly” and are penalized if they are dishonest or fail to complete the work as required. This functionality is available now, long before the Ethereum network starts listening to the Beacon chain for consensus on new blocks. However, users will not be able to withdraw their staked ETH (both the reward and penalty portions) until the Shanghai upgrade.

To participate in this process, users must have the software required to validate and propose new blocks (execution and consensus clients) running on their system. They must also generate a public and private key pair that the Beacon Chain can use to track new validators. Once completed, the user must deposit 32 ETH into the Beacon Chain deposit smart contract and enter their public key (and some other credentials) as data for the transaction.

A successful deposit issues a "receipt" on the execution chain, formally called a "log". This receipt contains data about the amount of the user's deposit and registers their deposit on the Beacon chain. The Beacon chain reads these "logs" from the execution chain and includes the new staker in the activation queue. This operation is processed as a transaction on the Beacon chain, similar to how smart contract functions are executed on the execution chain.

ETH in the Deposit Smart Contract

The ETH that a validator sends to the Beacon chain smart contract will remain there forever, because the smart contract is not written to have a withdrawal function and cannot be upgraded. Instead, the record of the validator's balance during its staking cycle (including the reward and penalty parts) will be processed separately by the Beacon chain before approving the final withdrawable balance.

This means that the execution layer balance of the Beacon Chain smart contract will be the cumulative amount of ETH staked by the validator. This balance should be deducted from the circulating supply of ETH on the network, as described in the "un-staking" process below.

Un- Staking Process

After the upgrade, validators will be able to make two types of withdrawals: partial withdrawals and full withdrawals. For both cases, validators must also be active for 2048 time periods (about 9 days, one slot every 12 seconds, 32 slots per time period) before they can signal an "exit".

Withdrawal

When withdrawing the full amount, the validator must first stop participating in validation. They can do this by sending a Voluntary Exit Transaction to the Beacon chain.

Once a validator is considered exited and able to withdraw, they can send a final transaction to initiate the exit. When validators submit full or partial withdrawal requests, they are added to a single withdrawal queue. The network will only process 16 withdrawal requests per block, following a first-in, first-out rule by including the first 16 withdrawal requests in the queue. This results in approximately 115,000 validators (exited and able to withdraw) being able to withdraw on any given day.

When a withdrawal is processed, new ETH that was not previously in circulation will be minted to the withdrawal address specified by the validator. As mentioned earlier, this new ETH is not removed from the Beacon chain deposit contract where the validator originally deposited its stake. It is important to note that any transactions required to complete the "unstake" process will not incur gas costs for the validator.

Possible impact

Neither the staked ETH nor the increase in ETH supply due to staking rewards to validators since the inception of the Beacon chain has yet to enter the spot market. This ETH remains locked on the Beacon chain until withdrawals are enabled. This means that the unlocking of the Shanghai upgrade has the potential to significantly increase the token supply, as (at the time of writing) there are 1,116 validators who will be able to withdraw after the unlock.

The limits placed on the final withdrawal queue exiting the Beacon chain mean that a maximum of 16 validators in a single slot can exit. Assuming every validator is fully withdrawn (validators will need to be "exited and withdrawable"), and each validator has a staked balance of 32 ETH (assuming the 32 ETH validator nodes are discrete, which is a reasonable assumption, but other analyses vary), this means a maximum of 3,686,400 ETH per day. However, this unlocking rate is only possible if there is a backlog of more than 6 validators in the final withdrawal queue.

In the long run

However, we should not underestimate the backlog of users waiting for immediate withdrawals, which is less than 1% of the 500,000 validators. This group collectively chooses to lock up over 16M ETH (~$26.8B at $1,673 per token) without a guaranteed withdrawal date. We believe that the unlocking may eventually lead to an increase in staked ETH, as stakers feel more comfortable locking up their ETH knowing it is retrievable.

We also believe that an increase in successful withdrawals is likely to reinforce confidence in the network, leading to a net inflow of new stakers in the medium to long term. The operational costs of participating as a validator are much lower than mining on a proof-of-work chain. Therefore, validators will not face pressure to withdraw their staked positions to cover computational costs. This gives us confidence that a large-scale outflow of validators is unlikely after withdrawals are allowed.

In the short term

However, in the short term, we believe that a large number of validators will want to perform partial withdrawals of their Beacon chain balances, which could result in a net outflow of Beacon chain ETH. Validators are incentivized to perform partial withdrawals of their Beacon chain balances because there is no benefit to being on the Beacon chain if their balance exceeds 32 ETH. By not performing partial withdrawals, validators essentially lose access to their ETH, losing both the wife and the army.

In addition, we believe that users who wish to stake their ETH will not withdraw their ETH immediately, but will wait and see whether the withdrawal process goes smoothly. In the short term, these two phenomena may hinder the inflow of ETH into the Beacon chain.

Liquidity Staking Tokens

Liquidity staking tokens have become one of the most popular ways for users to stake ETH on the Beacon Chain, allowing users to trade their staked positions using a tokenized version of their staked ETH. This remains a popular staking method because it facilitates centralized staking, similar to the mining pools that dominate Bitcoin’s hashrate. Liquidity staking providers lower the threshold for staking and allow users with less than 32 ETH (about $52,000 as of February 9) to receive staking rewards.

Additionally, they will continue to allow faster unwinding of staked positions, where users can sell their tokenized staked positions directly for ETH on an on-chain spot exchange, rather than completing the full withdrawal process outlined above, which may take longer transaction times at the cost of paying gas fees for their execution layer transactions.

Other Upgrades

As mentioned earlier, the Shanghai-Capella “double upgrade” includes a series of upgrades in addition to the activation of Beacon chain withdrawals. There are also the following two upgrades worth noting.

Warm Coinbase Upgrade (not related to Coinbase exchange)

Involves EIP-3651.

This upgrade is primarily intended to enable user optimization. It allows users to set an initial Gas fee to be paid to miners, and then increase or decrease the Gas fee if certain conditions are met. This upgrade particularly helps MEV searchers who want to optimize costs by dynamically adjusting fees, which previously had to be a fixed value.

PUSH0 instruction upgrade

Involves EIP-3855.

This upgrade aims to reduce the average size of smart contracts by adding a basic instruction PUSH0, which allows adding 0 to a byte. Before this upgrade, other non-dedicated instructions were used to fill bytes with 0, but using dedicated instructions consumed more gas, relatively speaking. This upgrade plans to introduce this dedicated instruction, which will help Ethereum developers reduce gas costs when deploying smart contracts on the network.

Summarize

The upcoming Shanghai-Capella “double upgrade” will mark another important milestone in the Ethereum Foundation’s future network roadmap. For more than two years, validators have been willing to stake their ETH on the network without access rights, which is the focus of this upgrade. We believe that in the medium to long term, the success of this upgrade will lead to more ETH being locked in the Beacon chain as investors are actively looking for sources of yield on tokens in a bear market. We believe that “token retrievability” will solve the pain point of low participation of many ETH holders who have not yet staked.