Bankless: 10 Things You Need to Know About Ethereum Merger

Mergers are so confusing!

Let’s start from the beginning and walk through one of the most important upcoming events in cryptocurrency history.

1. What is “merger”?

The “merge” is the name given to the Ethereum blockchain’s switch from using proof-of-work (PoW) to proof-of-stake (PoS).

The merger is called this because it refers to the merging of two separate blockchains that are currently running in parallel. The Ethereum main chain is being “merged” with a special-purpose blockchain called the Beacon Chain.

The beacon chain went live on December 1, 2020. The purpose of the beacon chain is to do one and only one thing: become a proof-of-stake blockchain.

There are no transactions on the beacon chain. There are no tokens or DeFi applications. It is an empty blockchain, a blockchain that is used only to run the proof-of-stake consensus mechanism.

Because the beacon chain is an “empty chain”, it can be merged with the Ethereum blockchain and replace Ethereum’s PoW mechanism without having to consider any other variables.

Once the two chains merge, Ethereum’s PoW verification mechanism will be replaced by a new PoS consensus mechanism.

2. Why is the merger so high profile?

The merger is considered one of the biggest events in the history of cryptocurrency since the creation of Bitcoin.

There are several reasons for this belief:

No blockchain in the history of cryptocurrency has ever undergone such a major transformation. Blockchains don’t often change such critical parts of their operations, and no chain has ever undergone a transformation on the scale of Ethereum, which has built such a large and robust economy.

ETH assets are now worth $203 billion (once $550 billion), and there are billions of dollars worth of other assets on the Ethereum network. Ethereum is by far the largest and most robust economic ecosystem in the cryptocurrency world, and the security of all these economic activities will shift from a PoW-based economy to a PoS-based economy.

Of course, there are a lot of risks associated with a merger if it goes wrong, which is one of the main reasons why the merger has waited so long.

There is still much, much, much testing and optimization to do.

3. How does the merger affect ETH?

The merger has a huge impact on the ETH economy. For investors, this is the most important point of the merger.

The merger will completely change the ETH economy in two ways: reducing ETH issuance and making ETH a native yield asset.

Reduce ETH issuance

The merger will reduce ETH’s annual issuance from 4.3% to 0.43%.

This is because the PoS consensus mechanism will bring fundamental improvements in efficiency. PoS aims to provide the highest level of blockchain security at the lowest cost, passing these savings to ETH by reducing the amount of ETH issued for security needs.

PoW is expensive and requires a large amount of resource expenditure to compensate the services of security providers (miners).

In contrast, the security cost of PoS is only the opportunity cost of funds, and does not involve any real-world goods or tangible costs. Unlike PoW, PoS does not need to issue a large amount of currency to pay for security. Therefore, the lower security cost makes the PoS consensus mechanism more efficient.

Ethereum was able to reduce annual ETH issuance from 4.3% to 0.43% due to the reduced need to pay PoW miners. A reduction in new ETH issuance is generally considered…very bullish.

This is because PoW miners sell the majority of their proceeds immediately, and over time their sales will account for more than 90% of the total mined.

With PoS, issuance is reduced by more than 90%, but the indirect costs of being a PoS validator are also basically reduced to 0.

PoW advocates believe that the high cost of PoW blockchains is a feature, not a bug. They believe that such a cost model creates volatility in assets, thereby preventing centralization because sellers are forced to pay PoW miner costs. While PoW may promote asset decentralization, it also has the side effect of centralizing security.

4. Why would the merger make ETH deflationary?

Almost exactly one year ago, on August 5, 2021, Ethereum launched the EIP-1559 protocol, an upgrade that changes the way Ethereum transaction fees are managed.

Compared to simply paying all transaction fees to miners before, most of the transaction fees will be destroyed.

This is done for a number of reasons.

After the merger, the issuance of ETH dropped by more than 90%, and the destruction ratio of ETH in each block increased.

When Ethereum's gas fee is greater than or equal to 7gwei, the destruction rate of ETH is higher than its issuance rate, resulting in a decrease in ETH supply.

During the peak of the bull market, gas prices were at 200gwei or higher for months, making the 7gwei threshold very low. This is still the case even in the current bear market.

5. Will the merger reduce Ethereum gas fees?

Not really.

This is a misunderstanding of "ETH 2.0" and "merger".

“ETH 2.0” is a name for the future state of Ethereum that is no longer used by the Ethereum community. “ETH 2.0” refers to the future version of Ethereum that will enable PoS and sharding.

At one point in Ethereum’s history, it was thought that PoS and sharding had to be updated at the same time. But as research and development progressed, developers realized that they could separate the two updates and release them separately.

Unfortunately, the term “ETH 2.0” has persisted.

Sharding will reduce Ethereum’s gas fees on L1, but true gas fee minimization or even elimination for end users will ultimately occur on L2, such as Optimism, Arbitrum, Polygon, StarkNet, zkSync, or other L2s.

When the gas fee of Ethereum L1 is reduced, the L2 fee will be reduced by a larger order of magnitude. Ethereum's gas fee solution has never been to reduce gas fees on L1, but to migrate users to L2 so that they can enjoy the fast and low-cost transaction experience brought by L2.

6. Will the merger increase Ethereum transaction speed?

This is actually the same question as whether the merger will reduce gas fees, just stated differently.

Transaction volume and transaction costs provide the same supply and demand dynamics in crypto networks.

Ethereum’s block time (how often blocks are added to the Ethereum blockchain) will indeed be slightly faster after the merger, from an average block time of 13.6 seconds to 12 seconds.

This means a 12% increase in transaction capacity, and therefore a 12% reduction in gas costs.

But this amount is minuscule and should not be considered as “lowering gas fees”.

7. Will the merger reduce Ethereum’s energy consumption?

Yes. And it will be greatly reduced. This is also the main purpose of merging and PoS.

After the merger, Ethereum's energy consumption will be reduced by 99.95% compared to the current level.

PoS uses capital rather than energy to secure the blockchain. Therefore, the energy required to maintain Ethereum is equivalent to the basic usage of a computer; that is, the energy consumed by what you are doing right now, such as reading this article, tweeting, downloading movies to your hard drive, etc.

With PoS enabled, Ethereum’s energy costs are only the same as running a single node — about 2.6 megawatt-hours per year. That’s less than the entire U.S. gaming industry consumes, or about 1,300 times less.

Ethereum will truly become the most environmentally friendly financial system in the world.

The banking and finance industries still require people to drive around in internal combustion engine cars, keep lights on in physical buildings, and otherwise consume energy that is no longer needed in the crypto world.

Maybe Wall Street should go green by using Ethereum.

8. Will ETH stakers sell ETH after the merger?

No! They won't!

After the merger, the business of withdrawing ETH from the ETH staking node will not be enabled immediately. This is because we want to keep everything as simple as possible when Ethereum is undergoing the largest and most complex upgrade in the industry's history.

The withdrawal function is expected to be enabled 6-12 months after the merger.

So, will stakers sell their ETH when withdrawals are enabled?

Maybe, but there will still be limits. There will be a withdrawal/deposit queue that limits the speed at which people can stake and withdraw. This is also a mechanism to keep the chain stable, preventing rapid fluctuations in the Ethereum application layer from affecting the security of the chain.

The deposit and withdrawal bottleneck limit is X/ETH per day, where X =:

#validator /65536, rounded to the nearest integer.

65536 is 2 to the 16th power. For some reason, Ethereum developers love these square numbers.

Currently, there are 433,916 Ethereum validators on the beacon chain. To find out how many validators there are per epoch, divide it by 65,536 and round up to the nearest integer.

433,916 (total validators)/65,536 ≈ 6 validators/epoch

So the number of activations/deactivations is 6 validators per epoch. An Ethereum epoch is 6.4 minutes, and 24 hours is 225 epochs.

So, the current validator activation/deactivation rate is 1350 validators per day.

225 epochs * 6 validators/epoch = 1350 validators/day

Each validator has 32 ETH, so the maximum amount of ETH unlocked per day is 43,200.

32 ETH * 1350 validators = 43,200 ETH

Additionally, the APY for ETH stakers will also increase after the merger since ETH stakers will also receive transaction fees.

This is expected to increase ETH yields from 4.2% to over 5%, but even higher at high gas consumption.

9. Why 32 ETH?

Why does it take 32 ETH to run a node, and not 31, 33, or some other number?

The answer is that the more nodes there are, the more total messaging between nodes there is. If the amount of ETH is lower, more nodes can be online. While this is good for decentralization, it also limits capacity.

32 ETH was chosen as the optimal balance between the two spectrums, and it is a square number: 2 to the fifth power.

Since node messaging is exponential, reducing the number of ETH validators from 32 to 16 will increase the messaging of all nodes by 4 times. Therefore, 32 was chosen as the minimum number of ETH stakes that can produce "finality" within 768 seconds or "2 epochs".

Will it always be 32 ETH?

Not necessarily! 32 could certainly be modified to 16 or lower with optimized consumer hardware, message compression, and better signature aggregation.

10. Proof of Stake is not on-chain governance

A criticism we often hear (mostly from the Bitcoin camp) is that PoS is equivalent to the “fiat system” we are trying to escape from.

What they are saying is that those who control the money also control the power.

This is a huge misleading statement. Many of the staunch supporters of this view may be spreading it maliciously to discredit any consensus mechanism other than Bitcoin.

The role of an ETH validator is exactly the same as that of a PoW miner. It is a 1:1 comparison.

ETH holders have no governance power over Ethereum. Just like Bitcoin, that power is held by non-validating node operators (aka “the community”).

It is rather ironic that these camps promote PoS as a “rich get richer” scheme, when it is an indisputable fact that PoW mining facilities generate greater returns on investment for wealthier, more capitalized entities than for smaller capitalized entities.

Some thoughts:

PoS Ethereum has ETH native returns and is the most democratic consensus mechanism because it provides the same return ratio regardless of whether it is 32,320, 3,200 ETH or 32,000 ETH.

They will all get the same interest rate of about 5%.

This is in stark contrast to PoW miners, where a $100 million investment in a mining facility will generate far more than 10 times the hash power of a $10 million investment due to economies of scale resulting from PoW hardware and energy costs.