After Ethereum POS, the choice of miners

Preface: Changes in the mining ecosystem due to the impending “merger”

In mid-July, Ethereum core developer Tim Beiko predicted that the merge upgrade implementation date for Ethereum's consensus algorithm migration to PoS would be September 19, which caused a shock to the entire Crypto industry. The merger is to merge the PoS-running beacon chain with the PoW-running original chain, and gradually stop the PoW part of the original chain. This upgrade means that Ethereum will switch to PoS consensus in the near future. This is a key step on Ethereum's road to 2.0, and it has also attracted much attention because it involves the transformation of the public chain consensus. Among them, the miners may be the most concerned about this trend because it is highly related to their vital interests.

The data that can directly reflect the boom and bust trend of the mining industry is the computing power of Ethereum. According to OKLink data, the current computing power of Ethereum is about 0.88P, compared with the scale of 1.05P in early May, its computing power has shrunk by 16%. This shows that many miners are gradually withdrawing from Ethereum mining. On the other hand, some miners have united and are waiting for an opportunity to promote the fork of Ethereum.

(Average computing power of the entire Ethereum network, image from OKLink)

So, what are the reasons for the decline in Ethereum computing power? What is the connection between "merger" and Ethereum's fork? This report aims to use a comprehensive clue and a closely linked deduction to help readers understand the changes that will occur in the Ethereum mining industry under the background of "merger". In the beginning, this report will also dismantle in detail the reasons for the recent huge decline in computing power, the role of Ethereum's "merger" in Ethereum 2.0, and explore the impact of Ethereum's transition from POS consensus to POW on Ethereum. This report is for reference only and does not constitute any investment advice.

1. Reasons for the decline in computing power

The scale of Ethereum computing power has shrunk by 16% in two months. The reason is that, on the one hand, the disappearance of the industry bubble and the cannibalization of market share by competing products have jointly led to a decrease in the demand for the use of ETH by projects, which has further led to a drop in the price of ETH. On the other hand, the established improvement plans such as EIP-1159 and Ethereum 2.0 have changed the income structure of Ethereum miners. From EIP-1159 to the launch of the beacon chain, the share of POW mining has been directly reduced, and then to the expectation that POW mining will gradually shift to POS mining after the "merger". They will all lead to less profit for current Ethereum mining machines, which in turn has jointly contributed to the shrinking scale of Ethereum computing power.

The most direct factor affecting miners’ mining behavior is profit. According to the mining machine profit formula:

Profit = Mining machine ETH income - Mining machine operating costs

Profit = Current ETH price * Amount of ETH obtained by the mining machine - Mining machine operating cost

The factors that affect miners' profits mainly include the amount of ETH obtained by the mining machine, the current price of ETH, and the operating costs of the mining machine. Since the operating costs of a single mining machine will basically not change significantly over a period of time, this article will further analyze the current price of ETH and the amount of ETH obtained by the mining machine.

1.1 Price drop caused by reduced ETH usage

The relationship between supply and demand is the most basic law of economics, and prices are determined by supply and demand. If demand decreases and supply remains unchanged, prices will fall. Ethereum is positioned as the world's computer. When a program needs to run on the Ethereum network, Ethereum needs to allocate sufficient network resources (computing, storage, bandwidth, etc.) to it, and ETH acts as a fee for using Ethereum network resources. From the perspective of supply and demand, the prosperity of the Ethereum network ecosystem determines the demand for ETH, and the current decline in industry bubbles and the erosion of market share by competing products have jointly led to a decrease in the demand for ETH in Ethereum projects.

1.1.1 Industry Bubble Extrusion

After experiencing the DeFi craze in 2020 and the NFT trend in 2021, the industry bubble gradually subsided, on-chain applications tended to shrink, and the frequency of users paying with ETH was greatly reduced.

In other words, the tightening of the industry due to cyclical reasons has compressed the circulation and application scenarios of ETH. According to the OKLink chart, since March, the daily destruction volume of ETH has continued to decline, which is significantly reduced compared with the previous destruction volume data, which indirectly reflects the reduction in the number of transactions processed on the Ethereum chain.

(ETH destruction amount, picture from OKLink)

1.1.2 Competitive products eat into market share

Many public chains are committed to solving the expansion and performance issues currently faced by Ethereum. Most of them are compatible with Ethereum code at the smart contract layer in order to quickly undertake Ethereum developers and divert a large amount of ETH usage demand. Typical representatives include Solana, Avalanche and Tron, etc.

According to the public chain TVL comparison data, although the pie chart on the left shows that the Ethereum public chain still ranks first with a share of 65.42%, the area chart on the right can clearly reflect that the TVL ratio on Ethereum has declined due to the erosion of other competing products.

(Public chain TVL chart, picture from defillama)

1.2 The reduction in the share of POW mining rewards has led to a decrease in the amount of ETH obtained by mining machines

According to the mechanism setting, Ethereum miners' income previously came from block rewards (fixed at 2 ETH) + handling fees, and the income from block rewards is usually higher than the handling fees. Since August 2020, affected by the DeFi and NFT craze, Ethereum chain activities have increased sharply, gas fees have soared, and the proportion of handling fees in miners' total income has gradually increased.

The high gas fees and waiting for packaged transactions caused by frequent congestion events in Ethereum have made the user experience very poor, which has greatly restricted the development of Ethereum. Established improvement plans such as EIP-1159 and Ethereum 2.0, while committed to improving the performance of Ethereum, have also changed the income structure of Ethereum miners. From EIP-1159 to "merged" POW mining share is gradually decreasing until it is 0.

1.2.1 EIP-1559 leads to reduced income for miners

EIP-1559 is an improvement proposal put forward by the Ethereum community to solve the congestion problem of Ethereum. Previously, miners' income came from block rewards and handling fees. Among them, the block reward is fixed at 2 ETH, and the handling fee is dynamically changing, and all belongs to the miners. After the implementation of EIP-1559, the handling fee will be destroyed, and the miners' income will only come from fixed block rewards and tips, and the tips are completely customized by the users. Therefore, under the setting of EIP-1559, part of the miners' income source will be destroyed, and the profit will be reduced.

(Changes in miners’ income before and after EIP-1559, picture from the Internet)

According to a previous Coindesk research report, after the implementation of EIP-1559, it is roughly estimated that miners' income will drop by 20% to 35% when the tip income is zero. According to OKLink data, since the implementation of EIP-1559, the estimated supply of Ethereum is 121,693,647.47 and the actual supply is 119,136,265.16. Currently, the Ethereum blockchain has destroyed 2,557,382 ETH, which is the part of the original miners' income reduction.

(ETH supply, image from OKLink)

1.2.2 Beacon Chain Online

Ethereum 2.0 is a planned solution to the current performance bottleneck of Ethereum network, and is committed to significantly improving the scalability and performance of the Ethereum network without reducing decentralization. To achieve this goal, it has set 4 development stages. The first three stages are all based on the PoW model. The fourth stage will complete the transformation from PoW to PoS, as well as important upgrades such as sharding and replacing EVM with eWASM, which is the final form of Ethereum. The Ethereum 2.0 network improves the scalability and processing power of the network by introducing sharding, and the beacon chain is the "command and control center" of the entire Ethereum 2.0 network.

Its latest roadmap shows that the main node beacon chain of Ethereum's fourth phase upgrade is online, "merged", and sharding. The beacon chain was launched in December 2020. Since then, the beacon chain has been running in the form of PoS. The process of generating blocks in the execution layer is still carried out by the original chain in the form of PoW. Ethereum has entered a stage of PoW+PoS mixed mining, paving the way for the entire network to transition to PoS.

The beacon chain is online, and the staking function is enabled. Users can deposit their Ethereum on the Ethereum 2.0 network. People can become validators by locking (staking) 32 ETH in the software and participate in verifying transactions to ensure the decentralization and security of the network. In return, stakers will be eligible for ETH rewards. This part also leads to a decrease in POW mining rewards.

As of July 29, the beacon chain is running smoothly. On-chain data shows that the beacon chain has about 411,000 nodes, with a total stake of about 13.132 million ETH, of which the effective voting participation rate is 99.83%. In addition, since December 2020, the number of nodes and the total stake have grown steadily, and the daily validator income is also growing slowly. At present, the total daily reward of the beacon chain is about 110,000 ETH.

(Beacon chain block data, image source: https://beaconscan.com/)

1.2.3 "Merger" is approaching, and will gradually switch to POS mining

According to Vitalik Buterin, the "merger" that Ethereum plans to carry out in the third quarter of 2022 will merge the consensus layer (PoS beacon chain) with the execution layer (PoW original chain), and gradually stop the PoW part of the original chain. This upgrade represents that Ethereum will officially switch to PoS consensus at bu jbu ji. Under the PoS mechanism, the Ethereum income that miners can obtain will be related to the proportion of their staked ETH to the total ETH staked in the entire network, and they no longer need to purchase hardware such as mining machines. This means that Ethereum PoW mining will soon exit the stage of history, which also brings certain pressure to miners who are currently conducting PoW mining.

The transition from Ethereum POW to POS mining is a gradual process. The difficulty bomb launched in September marked the beginning of the merger. The specific process can be summarized as follows:

Difficulty bomb starts -> block time is extended -> miners gradually leave -> network computing power decreases -> TTD is set -> reaching the final target difficulty

Degree->Switch from PoW to PoS (to achieve mainnet merger)

After that, under the PoS mechanism, the Ethereum income that miners can obtain will be related to the proportion of their staked ETH to the total ETH staked in the network, and they no longer need to purchase mining machines and other hardware. This means that Ethereum PoW mining will soon be phased out, which also brings some pressure to miners who are currently conducting PoW mining.

2. Impact of PoW to PoS Mining

According to the analysis above, this Ethereum merger means that Ethereum will switch to PoS consensus in the near future, which will have a huge impact on Ethereum mining. The main impact of PoW to PoS mining on Ethereum mining is reflected in the following four aspects: hardware equipment, total computing power, interest structure, and development direction. Let's talk about them one by one:

2.1 Mining hardware equipment - graphics card and other hardware providers shrink shipments

The industry's upstream hardware providers have benefited greatly from Ethereum's POW mining. Last year, Nvidia CEO Jensen Huang revealed that Nvidia achieved a profit of $155 million within three months of launching the Ethereum mining processor; in Q2 last year, Nvidia's graphics card mining revenue reached $266 million, a record high. Nvidia had previously publicly admitted that Ethereum's transition from POW to POS is a potential threat to demand for graphics card (GPU) products. On May 20, a week before the release of the Q1 financial report, chip giant Nvidia announced a slowdown in recruitment, which attracted special attention and focused interpretation from practitioners in the crypto circle. This active reduction in staff size may be inseparable from the sharp drop in demand for mining machines caused by the sluggish market.

As the leading player among the global high-end electronic hardware equipment suppliers and the upstream component manufacturer of crypto mining equipment, Nvidia will lower its shipment expectations due to the impact of the market downturn and Ethereum's conversion to POS, let alone other large and small players in the upstream, midstream and downstream of the industry chain. Of course, the impact of Ethereum's conversion to POS will be greater on them, because after all, compared with Nvidia, computing power mining is their "pillar industry" and even a drain on their income. Therefore, it can be foreseen that with the intensification of the downward trend in the market and the implementation of POS mining, the global shipments of physical mining equipment and its components will decline in the short term.

2.2 Market players in the mining industry: POW miners move elsewhere

All market players are born for profit, which is particularly evident in the crypto industry, especially in the mining industry. After Ethereum switches from P0W to POS mining, the original POW miners will no longer be able to participate in Ethereum mining, and the use of their existing ETH mining machines is worth paying attention to. Ethereum POW computing power plays a vital role in the entire crypto mining track and accounts for a large proportion. Once switched to POS, the original POW computing power may flood into other mining markets like a market crash, which may have a huge impact on the existing mining track and reconstruct the interest structure of the entire crypto hardware mining track to a certain extent.

2.2.1 Original chain fork

Faced with the redistribution of mining benefits, miners may not follow the Ethereum community to complete the PoS consensus mechanism conversion when Ethereum 2.0 is merged and upgraded from the perspective of interests. In this way, Ethereum may fork into two chains of POW and POS mechanisms at the merge node.

2.2.2 Turning to ETC Mining

The hard fork of the DAO incident caused the Ethereum community to split into Ethereum and Ethereum Classic, and the token was also divided into two - ETH and ETC. At present, the algorithms of the two are no longer the same. ETH ASIC miners may need firmware updates to be compatible with the ETC mining algorithm ETCHash. However, there are no technical barriers between the two. Existing ETH ASIC miners can mine ETC by only upgrading the miner firmware. Graphics cards do not need to be upgraded and can directly mine ETC. The switching cost is very low, which is likely to attract a large number of ETH ASIC miners to switch to ETC mining.

2.2.3 Other mining machine compatible coins

In theory, graphics cards can directly mine Grin, BEAM, RVN, XMR, BTG, AION and other currencies.

2.3 Overall output of mining industry: total computing power temporarily drops

Undoubtedly, according to the previous article, after Ethereum switched to POS, it mainly adopted the method of staking tokens instead of mining machine computing power for mining, which was also in response to the call for "carbon neutrality". Therefore, a considerable number of mining machines will be temporarily shut down and forced to stop, waiting to find new usage scenarios before restarting. Therefore, it is foreseeable that in the short term, the overall output of the mining industry - the total computing power of Ethereum will plummet, and the total computing power of the entire network will also temporarily decline to a certain extent.

As mentioned above, after switching to the POS mechanism, these original Ethereum miners and computing power will flow into other public chains and currencies that adopt the POW consensus mechanism, making their computing power more abundant. Then, this part of computing power will have a more uncertain impact on the price trend of the currency. Because the supply and demand relationship between the two has changed to a certain extent. Previously, the market demand for its currency increased, leading to price increases, which in turn caused a large supply of computing power. Now, these public chains and tokens have taken on a certain amount of computing power in an unexpected situation, giving rise to more tokens. Coupled with the weakening market liquidity under the Fed's interest rate hike, the currency price will become more volatile in the later period.

2.4 The development direction of mining industry - the rise of staking mining

After the "merger", Ethereum will gradually switch from P0W to POS mining. The threshold for users to participate in mining will be lowered. Users only need to pledge 32 Ethereum to apply to become a verification node to participate in mining. Therefore, the form of Ethereum mining will undergo a fundamental change, that is, from offline equipment mining to online pledge mining. As the pressure of "carbon neutrality" on the crypto circle increases, it is not ruled out that some public chains will follow the leading Ethereum and choose POS in the future. This will further compress the living space of physical equipment mining, but this is more of a trend.

Back to the reality, after the transition to POS, projects based on Ethereum staking services will become mainstream, and the Ethereum staking ratio will increase significantly before and after the merger. Staking services also have scale effects. When the pie is limited, projects with higher market share are more likely to increase the Staking share ratio through scale advantages, thereby further increasing their market share. The leading projects in this track are worth paying attention to, such as Lido.

In addition, since centralized trading platforms naturally accumulate various PoS chain assets and have relatively professional knowledge reserves and equipment resources, they have an advantage in staking operation services. In addition, trading platforms can directly open trading services for staking derivatives to release liquidity, so the current mainstream centralized trading platforms in the industry are mostly ETH2.0 self-operating node staking service providers.

OKX provides the service of ETH2.0 locked mining node operator. OKX bears the construction and maintenance costs of all ETH2.0 nodes. Users can participate with 0.1 ETH, and 100% of the on-chain income is distributed to users. The ETH2.0 mining income is dynamically adjusted according to the amount of locked positions on the chain, and the annualized rate of return is expected to be between 4% and 20%. The platform issues mining certificates BETH at a 1:1 ratio, takes a snapshot of user positions at 00:00 (HKT) every day, divides the on-chain income in proportion to the user's BETH holdings, and distributes mining income at 11:30 (HKT) the next day. When the ETH2.0 mainnet is launched, it can be exchanged back to ETH at a 1:1 ratio based on the amount of BETH held. In addition, the platform has opened BETH/USDT and BETH/ETH trading pairs. When you don't want to hold BETH, you can sell it at any time, which is highly flexible.

(ETH2.0 locked mining)

Conclusion: Ethereum's transition from POW to POS is a technological upgrade and a redistribution of benefits

Based on the above analysis, we can draw the following conclusions:

The combination of industry bubble extrusion and competitor erosion of market share has led to a decrease in the demand for ETH in Ethereum projects. Established improvement plans such as EIP-1159 and Ethereum 2.0, while committed to improving Ethereum performance, have also changed the income structure of Ethereum miners, resulting in a decrease in miners' mining share. These factors have combined to reduce miners' income and thus reduce the scale of Ethereum computing power. However, this is also an invisible and important connection with this round of Ethereum mergers.

Under the established route of Ethereum 2.0, Ethereum's transition from POW to POS is a technological upgrade on the one hand, and a redistribution of benefits on the other. In the POW era, miners contributed to maintaining the high-quality operation of the system and received huge ecological rewards. After switching to POS, the original POW miners will no longer be able to participate in mining, and there is a possibility of forking new chains, "mining" ETC or other mining machine compatible coins. Nodes and pledge services based on Ethereum Staking will become mainstream in the ecosystem.

Since its birth, Ethereum has gone through two rounds of industry cycles and is still the benchmark of the public chain ecosystem and the source of blockchain innovation. At present, many attempts have been made in various underlying technology breakthroughs, including Layer2 and Ethereum 2.0. The previous POW mining has contributed to the security and stability of the system. After the "merger" and the gradual transition to POS mining, the competition in the public chain ecosystem will enter the 2.0 stage. The all-round competition of public chains in the underlying, application, capital and other aspects is worth looking forward to.

At present, for assets with unlimited total amount such as ETH, there is no "story" of constant total amount of BTC, and the price is mainly maintained by "supply and demand relationship": that is, the dynamic balance between the amount of new additions and the amount of burning. The amount of burning is closely related to ecological applications. It represents the need to maintain "trust" in the decentralized digital world. Only when the ecology becomes richer and the demand for "trust" increases, can the prosperity of the ETH ecology continue. Therefore, what determines the development prospects of blockchain is the prosperity of the developer ecology on it, and "out-of-circle" applications are the existence that leads the future of blockchain.

It can be seen that the impact of Ethereum's transition from POW to POS mining on the Ethereum mining industry is particularly far-reaching, comprehensive, and even fundamental. In addition, we will also track and study the impact of the merger itself, including the future Ethereum 2.0, on the Ethereum ecosystem and even the entire crypto circle. Including the development direction of the subsequent pledge track, whether it will reversely siphon the ecology of other public chains, and the future of Layer2 track projects, etc., a series of potential impacts, the European Yi Research Institute will choose the opportunity to issue a special research report in the future to provide readers with in-depth interpretation.