The ideal and reality of Ethereum merger

Since Ethereum adopted the proof-of-work consensus algorithm, it has been looking for a better algorithm to make Ethereum a decentralized, scalable, secure, energy-efficient and environmentally friendly network. It was not until 2017 that Ethereum finally determined a hybrid PoW/PoS system - Casper the Friendly Finality Gadget.

In the years that followed, the Ethereum Merge was repeatedly delayed, and its slow progress also made many Ethereum supporters gradually lose confidence. Until June 8 this year, Ethereum successfully completed the first Merge rehearsal on the test network Ropsten. If nothing unexpected happens, the Merge will be completed within this year.

Merge will have an impact on the Ethereum ecosystem and even the entire blockchain landscape. This article attempts to explain the principles, advantages and disadvantages of Merge, and conduct an in-depth analysis of its impact, hoping to bring more perspectives to everyone, so as to better grasp the investment opportunities in the new situation.

We believe that despite some controversies about Ethereum's Merge, such as "wealth is more concentrated", "MEV risks are more serious", and "repeated delays", in general, the PoS mechanism is more conducive to making Ethereum more secure, decentralized, and energy-efficient than PoW. Merge and subsequent sharding and Layer2 will make Ethereum more scalable and bring better user experience. In short, Ethereum will become a better ecosystem.

After the Merge, the issuance of ETH will be reduced by 90%, and the inflation rate will be greatly reduced. With the cooperation of the EIP1559 protocol, ETH is likely to become a deflationary asset, which will help push up the value of ETH. Crypto quantitative trader Ryan Allis proposed a novel point of view when he was a guest on the Bankless podcast: Ethereum adopts a staking model after switching to PoS, which means that ETH has fundamentals and cash flow. If the DCF valuation method is used to value it, the value of ETH will reach at least 10,000 US dollars, which will attract more institutional investors with large funds. In addition, the PoS staking mechanism will also bring huge dividends to the staking track, which is worthy of attention and layout.

The first half of this article introduces the process and principles of Ethereum merger, and the second half focuses on analyzing the above viewpoints.

The following is the table of contents of this article. It is recommended to read the key points in detail.

?

01. What is The Merge?

02. How does The Merge happen?

03. Development progress of The Merge

04. Design Concept of PoS

05. Advantages of PoS

06. Risks of PoS

07. The impact of Merge

08. Investment perspective after the merger

01.

What is The Merge?

In 2013, Vitalik Buterin and Gavin Wood published a white paper envisioning Ethereum, the "next generation smart contract and decentralized application platform." After initially adopting the proof-of-work (PoW) consensus algorithm in 2015, Ethereum's vision has always been to become an energy-efficient proof-of-stake (PoS) network. In the first few years, the Ethereum community made great efforts to develop a PoS consensus mechanism with ideal security and efficiency; going through ideas such as "Slasher" and "Stake Consensus" until finally settling on "Casper the Friendly Finality Gadget", a hybrid PoW/PoS system, in 2017.

The Ethereum mainnet is currently secured by the PoW mechanism. In order to make a smooth transition, a beacon chain using the PoS mechanism will be introduced to run in parallel with the mainchain. Merge is to merge the two systems together. It replaces the current Proof of Work (PoW) consensus mechanism with a more environmentally friendly, efficient and secure Proof of Stake (PoS) consensus mechanism. When the merger occurs, the current PoW consensus mechanism will be completely abolished, and all blocks on Ethereum will be generated through PoS.

For a huge ecosystem like Ethereum that has been running for 8 years, switching consensus mechanisms is not an easy task. It is equivalent to replacing the engine while the plane is still flying. The value of on-chain assets is as high as hundreds of billions of dollars. Once there is any mistake in the upgrade and merger process, the consequences will be hundreds or thousands of times more serious than in the early days. Therefore, the development team will be more cautious in promoting the merger and upgrade of Ethereum.

02.

How did The Merge happen?

Parallel chain -> Merge -> Replace

This merger is conducted on the principle of "minimum disruption", which allows the original application clients to switch to PoS without any sense of disruption. The beacon chain first exists as an intermediate layer above PoW, similar to the second-layer consensus network. When the "merger" is completed, this layer will be directly used as the consensus layer, and the execution-related components in the PoW layer will be combined into the new consensus layer, and PoW will no longer exist.

The beacon chain blocks will contain the execution layer, which is the merged equivalent of the current PoW chain blocks. For end users and application developers, the execution layer is where they interact with Ethereum.

No transactions completed on the Ethereum network will be lost in this transition - The Merge will not have any impact on the data layer of the Ethereum network.

Safety mechanism principle

Staking Mechanism

In Ethereum's PoS, anyone can stake 32 ETH to become a validator - a node that participates in the network's consensus algorithm, responsible for storing data, processing transactions, and adding new blocks to the blockchain. Finalizing a block requires signatures from 2/3 of active validators to ensure the security of Ethereum. In this process, stakers receive staking rewards. Currently, the beacon chain only allows the deposit of ETH, and you have to wait until at least the Ethereum mainnet and the beacon chain merge before you can retrieve your staked ETH.

There are always risks when making large-scale changes to a protocol that secures hundreds of billions of dollars in assets, but thankfully, the current PoS Ethereum chain, the Beacon Chain, has been running without any glitches since December 2020.

To ensure safe and smooth operation, there are currently 4 unique client implementations of PoS Ethereum nodes. This means that if PoS node operators encounter issues with a particular implementation, they will have the ability to switch to a different client.

Forfeiture Rules

If a malicious actor attempts to tamper with the underlying protocol by using a large number of validators to revert a completed block (the equivalent of a "51% attack" in PoW), their funds will be slashed - meaning they will lose a portion of their staked ETH. This makes attacks very expensive. It's like a PoW system where if you use mining hardware to attack the network, your hardware will be destroyed.

In a PoS network, a proposer mines a new block, and the prover votes to approve whether the block becomes part of the blockchain. Slashing means that the validator violated the rules and was forced to exit. There are three slashing conditions:

• As a proposer, the node signed more than one beacon block for a block

• As a prover, the node signed more than one attestation on the same target

• As the attestor, the node signed a proof that conflicts with history

If any of these behaviors are discovered, then the node will be forced to exit the beacon chain in the next 36 days or so. The penalty will continue to occur for about 36 days until the node can exit. The amount of the penalty will change depending on the network conditions.

Difficulty Bomb

The difficulty bomb is designed to greatly increase the difficulty for miners to verify transactions on the network, making mining profitability significantly reduced. Eventually, miners will be unable to verify blocks in order to discourage miners before the long-awaited merger.

As EthHub explains: “Ethereum’s ‘Difficulty Bomb’ is a mechanism that, at a predetermined number of blocks, increases the difficulty of the puzzles in the proof-of-work mining algorithm, causing blocks to take longer than normal (thus reducing miners’ ETH rewards). This mechanism causes difficulty to increase exponentially over time, eventually leading to an ‘Ice Age’ — where mining on the chain becomes so difficult that blocks cease to be mined.”

The difficulty bomb was added to the code in 2015 as part of the plan to merge into the consensus layer. However, as the Ethereum merger was repeatedly postponed, Ethereum core developer Andrew Ashikhmin suggested that "delaying the difficulty bomb is the best option."

03 .

The Merge development progress

Speaking at the Shanghai Web3.0 Developer Summit last month, Vitalik said that the merger of the Ethereum mainnet and the beacon chain is expected to be completed in August 2022.

The merger process was difficult and tortuous. Since 2017, Vitalik Buterin has proposed to switch from PoW to PoS in 2019, but due to factors such as difficulty and security, it has been delayed and has not been completed. The main difficulties are: the amount of funds is huge, and the coordination and communication of interests of all parties involved is very cumbersome and complicated.

On March 15, 2022, the Ethereum merged public testnet Kiln went online, indicating that it has successfully transitioned and upgraded to a full PoS mechanism. On June 8, 2022, Ethereum completed the first rehearsal of Merge - the testnet Ropsten successfully completed the merge. Ropsten was launched in 2016 and is the longest-running Ethereum testnet to date. According to Ethereum core developers, about 14% of validators experienced downtime during the Ropsten merge process, but most of them were caused by incorrect node configurations, and these problems were quickly resolved. In addition, the merge on Ropsten is considered to be nearly perfect and has become an important milestone in Ethereum's migration to PoS. In the future, the merge will be performed on the Sepoli and Goerli testnets. If all goes well, the Ethereum mainnet is expected to complete the merge between late August and November.

What is the work route after the "merger"? According to the disclosure of the Ethereum Foundation and its core developers, we summarize it as follows:

• 2023, The Surge

The merger will not reduce Ethereum's gas fees, but The Surge is committed to solving Ethereum's traffic congestion and high gas costs. Ethereum will be cut into 64 shards, combined with Layer2's rollups technology, the theoretical upper limit of tps may be 100,000 transactions per second (current Ethereum tps is about 13 transactions per second).

According to the Ethereum Foundation's estimates, the shard chains should be online sometime in 2023, depending on the progress of the merged work. These shards will enhance Ethereum's ability to store and access data, but will not be used to execute code.

Note:

Sharding is a computer term that refers to the horizontal division of the database in order to distribute the load. Ethereum sharding refers to the creation of new chains/shards, with multiple shards processing data simultaneously, thereby reducing network congestion, increasing tps, and reducing gas fees.

• The Verge

As for the technical update, we plan to transition from the merkle tree to the verkle tree. They can be regarded as the database of Ethereum. At this stage, as the block data increases, it will in turn verify the scalability and decentralization of the network.

• ThePurge

The purge means that not all nodes have to store all historical blocks permanently. Instead, clients will stop storing history older than a year. This means that Ethereum will have lower hardware requirements for nodes and lower network bandwidth.

• TheSplurge

Miscellaneous upgrades to simplify the use of Ethereum and make it more accessible to ordinary users.

04.

The design concept of PoS

Ethereum founder Vitalik once explained the design concept of Casper PoS:

• Cryptography is one of the few technologies that is easy to defend but difficult to attack (the defender has more advantages than the attacker when facing an attack), just like attacking a castle is much easier than building a castle. An island is more defensive, but it is still difficult to avoid being attacked. In comparison, an ordinary person's key is safe enough to even resist attacks at the national level. Fundamentally speaking, the cypherpunk concept is to use this valuable asymmetry to better protect personal sovereignty. The crypto economy is an extension of this idea, except that it protects the security and effectiveness of coordinated complex systems, not just the integrity and confidentiality of simple private information. The ideological successors of the cypherpunk spirit should maintain this basic attribute and make the cost of destruction much higher than the cost of use or maintenance.

• The cypherpunk spirit is not just an idealism; creating systems that are easier to defend than to attack is also fundamental engineering.

• Humans have always been pretty good at using consensus. Even if an adversary were able to gain unlimited hashing power and perform a 51% attack on a blockchain, convincing the community of the legitimacy of this forked chain would be much harder than just outstripping the hashing power of the main chain. They would need to subvert block explorers, every trusted member of the community, the New York Times, archive.org, and dozens of other sources on the internet; in short, convincing the world of a new forked chain would be as hard as convincing the world that the U.S. moon landing never happened.

Note:

Hash power is the power of a computer to run and solve different hashing algorithms. These algorithms are used to generate new blocks on the blockchain. This process is also known as mining.

• However, a blockchain secured solely by social consensus is too inefficient and slow, and too prone to disagreements persisting indefinitely; therefore, consensus through economic means plays an extremely important role in protecting effectiveness and security in the short term.

• Because the security of PoW can only come from block rewards, and the incentive for miners can only come from the risk of losing future block rewards, PoW is a system that is motivated by a large number of rewards. It is very difficult for PoW to recover from attacks. Vitalik is not optimistic about this logic because (i) it consumes a lot of energy and (ii) it does not realize the spirit of cypherpunks. The cost of attack and the cost of defense are in a 1:1 ratio, so there is no defender advantage.

• PoS breaks this symmetry, relying not on rewards but on penalties to ensure security. Validators stake their money and receive a small reward to compensate them for locking up capital and maintaining nodes, and taking extra precautions to ensure the safety of their private keys, but most of the cost of reverting transactions comes from penalties, which are hundreds or even thousands of times greater than the rewards they received during this period. Therefore, to summarize it in one sentence, PoS is not "security comes from burning electricity", but "security comes from the loss of economic value invested."

Note:

Reverting transactions means that the logic of the smart contract being used fails or there is not enough gas to complete the transaction. The transaction is still executed by the miner, and any gas fees used before the transaction was reverted need to be paid. Based on this, the reverted transaction is still mined and included in the published block, but the state of the contract has not changed as expected.

05.

Advantages of PoS

When asked by Fortune magazine why PoS is a better mechanism, Vitalik responded:

I think there are a lot of benefits to Ethereum switching to proof of stake. In terms of environmental issues, it allows the Ethereum ecosystem to consume fewer resources. In addition, proof of stake can improve the security of the system. It makes it more expensive to attack and easier to recover the network from attacks, which people don't think about. In addition, proof of stake is more censorship-resistant , and the computers running the validating nodes are easier for miners to detect and shut down the program. So proof of stake has a series of different advantages.

Based on Vitalik's point of view, we further summarized:

1. PoS provides more security at the same cost

Let’s calculate the cost of attacking the network in PoS and PoW respectively in order to obtain every $1 block reward per day.

Note:

Due to the special mining mechanism of ETH, the Ethereum network has not developed high-computing ASIC mining machines like BTC. Currently, Ethereum mining is mainly GPU mining, and ASIC mining machines account for a very small share. Therefore, only GPU mining is considered here.

GPU-based PoW

The cost to an attacker to attack a network is to rent enough GPU power to outperform existing miners. For every $1 of block reward, existing miners spend close to $1 (if they spend more, miners will quit because it is unprofitable, if they spend less, new miners can join and make high profits). Therefore, attacking the network only costs a little over $1 per day and only takes a few hours.

Assuming the attack lasts for 6 hours, the rental cost of renting a GPU for 6 hours is about $0.26. As the attacker obtains block rewards, the cost may drop to zero.

PoS

The cost of PoS is mainly capital investment (i.e. the deposited coins) and the operating costs of operating nodes. The deposited coins will not depreciate, and when participants complete the pledge, they will get their deposited coins back after a period of time. Therefore, participants are willing to pay a much higher capital cost for the same amount of rewards.

Assuming that a return of about 15% is enough to incentivize people to stake, then a reward of $1 per day will attract $2,433 in deposits over a period of 6.667 years. The hardware and electricity costs of operating a node are small, only $100 per month in electricity and network fees, but a thousand-dollar computer can stake hundreds of thousands of dollars in deposits. We can conservatively assume that these ongoing costs are 10% of the total cost of staking, and the reward corresponding to the invested capital is $0.9 per day.

Total cost of the attack: $0.90/day * 6.667 years = $2189

Note:

6.667 years = 1 USD/(15% return); 2433 USD = 1 USD/day x 365 x 6.667

1/0.15=6.667 (return/IRR)

In the long run, this cost is expected to be higher as staking becomes more efficient and people become accustomed to lower returns. Vitalik expects this number to eventually rise to around $10,000.

The only "cost" incurred to obtain such a high level of security is that you cannot move your coins freely when staking. It is even possible that the total amount of funds locked up in the community and ready for productive investment remains the same, as the price of the coins will increase because they are locked up. In PoW, the "cost" of maintaining consensus is the large amount of electricity burned.

2. In PoS, attacks are easier to recover from

In a PoW network, if your chain is 51% attacked, what do you do? Historically, the only response so far has been to “wait until the attacker gets tired.” But this ignores the possibility of a more dangerous attack, a spawn camping attack — where the attacker attacks the chain over and over again with the explicit goal of rendering that chain invalid.

In a PoW network, a persistent attacker can easily render a chain permanently inoperable. In the first few days, the cost to the attacker may become very low and honest miners will quit because they have no way to get rewards while the attack is ongoing.

In a PoS network, things are much better. For certain types of 51% attacks (particularly reverting completed blocks), there is a built-in slashing mechanism in the PoS consensus, by which a large portion of the attacker's stake is automatically destroyed without affecting the stake of others. The first attack chain will cost the attacker millions of dollars, and the community will be back to normal in a few days. The second attack chain will still cost the attacker millions of dollars, because they need to buy new coins to replace the old coins that were burned. And the third will... cost more millions of dollars. This game is very asymmetric and unfavorable to the attacker.

3. More energy-efficient

PoS nodes are estimated to be 99% (or more) more energy efficient than PoW nodes, so PoS represents a huge leap forward in energy efficiency for blockchain technology. The PoW mechanism is very energy-intensive, and in order to produce each block on the network, participants need to use powerful and energy-consuming GPUs to solve a complex math problem, and whoever solves the block first gets the reward. Simply put, PoW is an arms race, and if you have more hash rate than your competitors, you are more likely to win. The end result of this arms race is that PoW miners run as many GPUs as possible at 100% load, 24 hours a day. The more block rewards they want to earn, the higher the demand for electricity.

In PoS, block proposers are randomly selected, and there will be no arms race. There is no need to consume more energy to increase competitive advantage, so there is no need for energy-intensive hardware like PoW. Any relatively new consumer hardware is capable of running the software required to operate a 32 ETH staking node. If you deposit more than 32 ETH, you will be assigned to multiple "validator slots" by the protocol, but you will still be able to run them from a single computer, although the more you stake, the higher the hardware requirements.

The adoption of the PoS mechanism will be more environmentally friendly and greatly reduce power consumption. One hundred thousand Visa transactions use 149 kWh of energy, while Ethereum PoS transactions consume only: 0.1667 * 4 = 0.667 kWh, which is equivalent to 0.4% of the energy used by the same number of Visa transactions. Compared with Ethereum's current PoW network, energy expenditure is reduced by 225 times.

4. Higher censorship resistance

To become a miner on a PoW network, you need to purchase mining hardware, cheap and reliable energy, and certain skills and abilities to run and maintain your "mine". The head effect of mining makes it difficult for small-scale mining to compete with large mines, and due to the large amount of electricity consumption, it is easy for central agencies to discover mines and shut them down or coerce them to participate in attacks. PoS staking can be done on an inconspicuous laptop.

06.

Risks of PoS

1. PoS is more like a “closed system”, which may lead to higher wealth concentration in the long run

In PoS, you can get more coins by staking your own coins. In PoW, you can always get more coins, but you need some external resources to support it. Therefore, in the long run, people are worried that the currency distribution of PoS may become more and more centralized.

Vitalik responded to such doubts as follows: In PoS, the rewards for validators are quite low; after Ethereum switches to PoS, it is expected that the annual rewards for validators will be equivalent to 0.5-2% of the total supply of ETH. And the more validators there are, the lower the interest rate. Therefore, it may take more than a century for the concentration to double. On such a time scale, people are more likely to consume, donate to charity, distribute property to children, etc., rather than waiting for the staked ETH to double.

2. PoS requires “weakly subjective”, while PoW does not

Although nodes that already exist in the network will not be deceived by attackers, for nodes that join the network for the first time, they do not have enough information to determine which chain was created first, so new nodes tend to choose the longer chain created by the attacker. To avoid this, new nodes need to somehow learn about the main chain off-chain, which essentially requires them to choose to trust a certain entity in the network. This third party can be their friend, an exchange or blockchain browser, or a client developer. PoW does not have such a requirement.

However, even though these two risks are significant, they are acceptable given the higher efficiency and greater ability to respond to or recover from attacks that can be gained from a PoS system.

07.

The impact of Merge

Impact on ETH

• ETH issuance dropped by 90%, and inflation rate dropped

Bitcoin halves its issuance rate every 4 years, and when Ethereum merges, it will reduce its issuance rate by about 90% because it no longer needs to reward miners for mining. The community calls this situation "Triple Halvening" because it is equivalent to *3 Bitcoin "halvings" happening at the same time. Ethereum will experience a reduction in issuance in an instant, while it will take an additional 12 years to match on the Bitcoin network.

Currently, Ethereum issues approximately 13,500 ETH per day in the PoW model (about 4.3% of the total ETH supply per year). However, the PoS issuance model is determined by the amount of active ETH on the network. Current predictions are that when the merger occurs, the issuance rate will drop to between 0.3% and 0.4%.

For comparison, Bitcoin currently issues about 900 BTC per day — an annualized issuance of about 1.7% of BTC’s total supply. The next two “halvenings” will reduce Bitcoin’s issuance to about 0.8% in 2024 and 0.4% in 2028. With Ethereum’s expected issuance falling to between 0.3% and 0.4% after the merger, Bitcoin’s issuance won’t match Ethereum’s until 2028.

When "The Triple Halvening" is combined with the BASEFEE burning mechanism of EIP-1559, it is expected that the issuance of Ethereum will actually become deflationary during periods of high user activity. Deflation means that as the currency has stronger purchasing power over time, the market circulation of ETH will be less than the actual circulation required. Deflation will also help boost the price of ETH.

Note:

EIP-1559 is the first step to transform ETH into a deflationary asset, and it has caused about 1.8% of the total ETH supply to be burned since its launch in August 2021. However, its destruction rate is uncertain, more will be destroyed when the network is busy, and less will be destroyed when the network is not busy.

• After the Merge, more and more people will choose to stake ETH, but it will also be easier to withdraw

Currently, about 9.7% of the ETH supply is staked. All staked ETH will stop circulating until the Merge is completed. Depending on the amount of staked ETH, network fees, and MEV after The Merge, the ETH staking yield may be between 8.7-10.3%.

As of June 12, about 13.46 million ETH has been staked, with about 400,000 validators and an APR of about 4.2%. Stakers will also receive the gas fees currently belonging to miners, which will increase the APR by 2 times or more. The 4.2% APR can be considered a nearly risk-free return on Ethereum. When it rises, it will attract more ETH to be staked.

But under PoS, it is easier for a node to withdraw. The difference between mining machines and ETH is that although mining machines have financial attributes, they are not completely financial products like ETH. Ethereum does not allow withdrawals before the merger is completed, so it will only increase in one direction. However, after the merger is completed, ETH will not have physical asset support after switching to PoS, and the amount of withdrawal is difficult to determine. It will indeed be less stable than before, and the volatility may be greater.

• Increased returns for staking users

Without deducting server costs, users who stake on Ethereum will receive an annual interest rate of approximately 4.2%. Kraken predicts in its report “Staking Status in the First Quarter of 2022” that after the Ethereum Merge is completed, the annual interest rate for staking users will increase to 8.5%-11.5%.

Staking Status in Q1 2022

• After the merger, a large number of users withdrew ETH, causing a serious crash to ETH?

Currently, staking ETH is a one-way operation, and stakers cannot withdraw their ETH rewards. After the Ethereum merger, withdrawals will be made, and when the 12 million staked ETH are unlocked, ETH will be sold in large quantities. This will cause a serious market crash on ETH.

We have reservations about this view for the following reasons:

1. Only 30k Ethereum can be withdrawn per day

2. Unlocked ETH will be released slowly

3. Staked ETH is usually someone who never sells it. Since there is no official date for this phase of the upgrade, users may have to wait for years to get their staked ETH back. The long lock-up period means that stakers are usually those who don’t mind having their ETH locked for quite a long time.

Impact on the Ethereum ecosystem

• Miners will no longer be able to mine on Ethereum

Before the merge, EIP 1559 was activated on Ethereum, and when the merge occurred, most of Ethereum's transaction fees had been burned for nearly a year. The remaining fees that were not burned after EIP-1559 (called "tips" or "priority fees") will be paid to the block proposers of PoS blocks, not PoW miners.

If any node continues to mine on the PoW version of Ethereum, they will become a minority in the fork, and the economic value of their block rewards will be far lower than their operating costs. Since miners are driven by profit, it is expected that the miner group after the Merge may:

1. Mining other PoW tokens

2. Data centers that provide high-performance computing

3. Providing computation for Web3 protocols

4. Sell mining machines and pledge mined ETH to participate in PoS

• Collusion Arbitrage in MEV

MEV stands for Maximum Extractable Value. A simple explanation of MEV is that a miner or validator in a blockchain network can determine the order of transactions in a block, and the maximum value that can be determined by this order is called MEV. It is similar to front-running transactions in traditional securities trading.

Currently, this scheme of sorting miners has not changed in PoW and PoS, but after PoS, the negative impact of MEV will be amplified: Under PoW, block proposers are randomly generated based on the computing power they have, and a mining pool with stronger computing power will have a higher chance of proposing the next block. But this is still random, and block proposers cannot predict in advance, so it is difficult to implement a multi-block MEV strategy. But under the PoS scheme, block proposers are pre-selected every 12 minutes, which means that block proposers adjacent to each other can not only extract MEV from their own blocks, but also collude to implement a multi-block MEV strategy.

This has two very important consequences:

1. The multi-block MEV strategy screens and sorts more transactions within a larger block space, thereby "stealing" greater MEV value.

2. Worse, it is extremely centralized.

a. A higher percentage of validators is under your control -> greater chance to control two or more adjacent block proposers -> more MEV is extracted

b. This means that centralized staking pools can not only provide more stable economic returns (as a single staker, the chance of proposing a block is quite small), but also because more MEV is generated, the economic returns will be higher. Therefore, people will likely give up fighting alone and join a centralized staking service or pool.

If Ethereum cannot reduce this risk, it is likely to destroy the entire Ethereum protocol. In response, the Flashbots team proposed the MEV-Geth solution. This broadcast in the Ethereum network mempool is more like a public auction. The source of MEV lies in the delay between the transaction being sent and the actual packaging by the miners. Flashbots' MEV-Geth solution allows transactions to not participate in the mempool public auction, but directly hand over the packaged transactions to the cooperating miners in order (not determined by the miners) for processing.

Note:

Mempool - an abbreviation of Memory and Pool, is used to store unconfirmed transaction information. It acts as a waiting area for transactions that have not yet been included in the block. It is also the place where the MEV robot searches for certain MEV transactions.

It is worth noting that after the merger, the transaction sorting process has not changed much. We also have reason to believe that MEV will continue to exist. The difference is that the people who decide the transaction order have changed from miners to validators, and validators will be randomly selected to participate in the execution of the beacon chain.

• Upgrading of technology platform

One of the key features that has made Ethereum such a successful platform and a worthy challenger to Bitcoin’s market dominance is the Ethereum Virtual Machine (EVM), which allows smart contracts to be created and used on the network.

To help improve this system and make it easier for newcomers to the platform, Ethereum will use a new system to replace the EVM after the upgrade, called Ethereum WebAssembly (ewasm). This system will allow developers to write code creatively and freely without having to learn the native Ethereum-specific language Solidity.

• PoS transforms ETH into Internet bonds, which is more regulatory friendly

The recently enacted Responsible Financial Innovation Act aims to encourage 'responsible innovation' by integrating digital assets into existing laws and provides a clearer framework for the crypto industry. The SEC will regulate digital assets classified as securities, while the CFTC will be responsible for overseeing those recognized as commodities. This may pave the way for the arrival of Ethereum upgrades, where PoS will transform ETH into Internet bonds - a viable alternative to US Treasuries . Although ETH is more volatile than bonds, it guarantees a higher yield, and if the ETH price does not plummet, the actual return will still be better. Ethereum's conversion to PoS may be a pioneering move that other cryptocurrencies may follow in the future, and even prompt some organizations or governments to fully accept cryptocurrencies. This approach can greatly promote the adoption of Ethereum and lead cryptocurrencies to a better future.

Impact on the competition landscape of public chains

Optimistic expectations:

• Everything went smoothly, Ethereum became the dominant blockchain, and even other public chains became Ethereum's Layer 2.

Pessimistic expectations:

• The Merge was repeatedly postponed, people lost confidence in Ethereum’s execution capabilities, other public chains emerged, and the Merge became a game of “Waiting for Godot”.

• Multi-chain infrastructure such as Cosmos has allowed the multi-chain ecosystem to flourish and encroach on Ethereum's market share.

Merge follow-up: expansion

The Merge is not an Ethereum expansion solution. Its scope is limited to upgrading Ethereum’s consensus mechanism. In practice, it will not have any impact on the current Ethereum user experience. Gas fee is a function of block space requirements and is not affected by the consensus mechanism.

The vision of Ethereum is to become a decentralized, secure, energy-efficient, and scalable network. After the Merge is completed, work on sharding and Layer2 will begin, both of which will have a significant impact on the scalability of Ethereum.

08.

Investment perspective after the merger

Ethereum costs have dropped significantly, is this a good thing?

The Ethereum Foundation holds approximately $1.6 billion, divided into $1.3 billion in cryptocurrencies and $300 million in non-cryptocurrency investments and assets. The vast majority (99.1%) of the cryptocurrency held is in the form of ETH, which accounts for 0.297% of the total ETH supply.

The ETH paid in Gas fee does not make any centralized entities profitable, and no company charges a share of the fees you pay, gas fee pays to miners because they contribute the necessary resources to keep Ethereum running. Therefore, you can think of gas Fee as the basic “material” required for network operation.

Income: When you use any Layer1, you pay native tokens for the services (that is, block space) they provide, and the income you pay will be owned by the asset holder in the form of staking rewards. This is Ethereum revenue (example: developers must pay the Ethereum network to create a new token or dapp on the network).

Expenditure: Hal Press, the founder of the crypto hedge fund North Rock Digital, proposed a novel perspective - for PoW, issuance is a fee, because the issuance is not owned by token holders, but by miners, so Ethereum now issues 4 million coins per year, which is a huge fee. However, after Merge, the issuance of ETH is no longer regarded as a expense, because under the PoW mechanism, miners tend to sell ETH in order to compensate for the hardware costs of their miners and other miners. However, under the PoS mechanism, stakers usually choose to pledge and hold for a long time. The pledge reward is still in the Ethereum ecosystem and does not leave the system, so this part of the issuance cannot be considered a cost.

Besides that, most of the expenses of PoW are electricity bills. This is the actual expense of the network, because for those who run the network, it is a matter of money, and although PoS still needs to run nodes and pay electricity bills, the expenses are much lower than before.

In 2021, the Ethereum Foundation will spend approximately $48 million. About $20 million of that is in the form of external expenditures, including grants, entrusted field allocations, third-party funding, bounty and sponsorships.

Although Ethereum costs have dropped significantly, is this necessarily a good thing?

Analogous to commodities or traditional currencies, the value is the sum of the means of production and other costs that need to be invested. Therefore, if the minting method of Ethereum changes, people's consideration of its intrinsic value will change. Pledged ETH becomes the new Ethereum, and Ethereum no longer needs to be withdrawn. Users can have the convenience of liquidity, and the book assets are rising. Just like an algorithmic stablecoin, which can obtain potential future returns through pledge, this method is likely to be a preview of future risks: once extreme risk events occur and external liquidity is impacted, the value between these two currencies will be deanned.

We all know the law of "conservation of energy". The reduction of external energy input may bring greater risks to the stability of the system. The liquidity of Ethereum and the expected management of future asset value is based on the existing PoW mining mechanism, which makes everyone think that assets "minted out of thin air" are valuable. However, if the existing incentive mechanism is changed, a decrease in minting costs may not be a good thing for the ecosystem, and it is likely to exacerbate the risk of the ETH death spiral and bring about a tragedy similar to an algorithmic stablecoin.

Ethereum can be viewed using traditional financial valuation method

When crypto quantitative trader Ryan Allis was a guest on Bankless's podcast, he proposed that PoS has given ETH a fundamental for the first time. According to the DCF and P/E valuation methods, the value of ETH is seriously underestimated, and its fair value will definitely be above US$10,000, which will attract the attention of more institutional investors.

Note:

DCF, Discounted Cash Flow, is a type of valuation of an asset's expected future cash flow (predictions of how much money it can make in the future). To build a DCF model for a company, you need to know its current net profit (income-expenditure), which is the annual cash flow. Then you need to assume the growth rate of these cash flows and evaluate it over a longer period of time (such as 15-20 years).

The cost of the Ethereum network is mainly the security cost required to maintain consensus. It is issued to block producers in the form of ETH (block rewards). It is currently a miner, but in PoS it is a staker in the Ethereum network. The network has no other costs, and hardware, power, etc. are borne by third-party suppliers.

Therefore, we have two types of cash flow:

• Burning expenses (equivalent to indirect distribution of profits to ETH holders through "repurchase")

• Tips and block rewards to stakers

Based on their expected growth rates of Ethereum revenue, it is possible to establish a DCF model to evaluate the fair value of ETH.

DCF Model Input:

• Annualized income = income in January 2022×12

• Growth rate: 25% per year (already conservative compared to last year's 400% growth)

• Pledge Reward: $1.1 million in ETH per year

DCF model output:

• DCF value per ETH: $10,600

• DCF value of ETH per pledged: $12,600

These numbers are calculated by dividing the net present value of future cash flows by the current supply of ETH. However, they ignore the deflation of the combined ETH.

If we assume that ETH supply will drop from the current 118 million to 100 million in 20 years (to 71 million at the current expected annual supply decline of 2.5%), the above prices will rise to $12,500 (not pledged) and $15,000 (pled).

The results of using valuations based on P/E (P/E) are more optimistic. Ethereum’s current P/E ratio is 20, while the average company in the S&P 500 has a P/E ratio of 35, with an average annual growth rate of 8-10%. Ethereum’s growth rate last year was 400%.

If we compare Ethereum to a fast-growing technology company, we can assume that the price-to-earnings ratio is 100-200 (Tesla is above 300), which will give the implied value of ETH per dollar of USD 17,000-33,000, a modest increase of 5-10 times the current price.

Not only do we have an asset with 100% revenue that is profitable, but its growth rate is more than 10 times the average growth rate of a company, but ETH's trading price-to-earnings ratio is still lower than that of an average company, and there is still a lot of room for growth.

There are also criticisms that trading in the cryptocurrency market is based on narrative and meme, and the DCF model is not suitable for this market. Maybe it is indeed not suitable now, but when more institutional investors enter the cryptocurrency field, the traditional valuation method will become more common, and even the DCF model may become meme itself, and if many people believe it, it will become relevant.

Good for pledge track service providers (staking as a service)

Pledge classification

• Solo home staking

Individual pledge means that the user pledged at least 32 ETH on Ethereum and operated the verifier nodes themselves. There are many restrictions on self-staking: 1) The pledged funds cannot flow, and ETH cannot be staking before the Ethereum upgrade is completed; 2) Many tasks of operating nodes in 24*7

• Exchange staking

Through centralized exchange pledge, users are allowed to pledge or cancel pledge at any time, and the exchange will withdraw a certain service fee. Since the initial user cannot retrieve the money pledged on Ethereum, the exchange has a certain pressure on the turnover of funds - the exchange can only pledge about 60% of the ETH deposited. Therefore, the return rate of pledge on the exchange is much lower than that of individual pledges or liquid pledges.

In addition, exchange staking poses centralized risks to the Ethereum network. Exchanges represent some of the largest ETH holders, and exchange staking makes their ETH holds larger, which will cause huge damage to the Ethereum ecosystem. The three largest custodial staking solutions (Kraken, Coinbase and Binance) have accumulated nearly 2.7 million ETH in total.

• Liquid staking

Liquid staking allows users to pledge any amount of Ethereum and facilitates them to unstake at any time. It is completed by issuing a tokenized version of the pledged funds, similar to a derivative that can be transferred, stored, consumed or traded like ordinary tokens.

For example, Lido allows users to pledge any amount of Ethereum in return for issuing stETH, which can be used for borrowing, staking, etc., while still receiving daily staking rewards. Since the ETH pledged by users generates staking rewards, the user's balance will increase every day, allowing them to get the value of the staking rewards.

Lido is suitable for all types of ETH holders. Holders of small funds can stake any amount of Ethereum and can be unsolicited at any time; holders of large funds can use the liquid staking service to hedge their funds against ETH fluctuations; basically, it allows parties to staking without maintaining complex staking infrastructure.

Pledge track market analysis

The Ethereum staking rate has reached 10%, and it will still grow more than 3 times in the future. Merge's promotion and completion are beneficial to the staking track service providers. Currently, about 370,000 validators have pledged 12 million ETH on the Ethereum beacon chain, exceeding 10% of the total Ethereum volume, with a total value of US$35 billion. Referring to the long-term staking rate of existing PoS main chains such as Binance and Solana, between 40% and 70%, the Ethereum staking rate still has at least 3 times the growth space.

Running your own pledged node will face many risks and require a lot of funds to start. It is difficult for individuals to maintain a 24/7 online server and keep it free of errors and be confiscated. In order to facilitate individuals to stake and earn rewards, "staking as a service" node suppliers have appeared in the market. Node suppliers will be responsible for managing infrastructure, and users only need to stake their funds on the platform provided by the node supplier, and the node provider charges node operation fees or commission fees every month.

Among them, Lido, which has occupied 90% of the market share of the liquidity staking track, has established an ETH exchange liquidity pool with Curve, allowing users to still obtain ETH liquidity during the period of pledge funds locking; Rocket has taken a differentiated route suitable for small retail investors with an ultra-low pledge threshold of 0.001 ETH; and SSVNetwork, as the underlying technology supplier, was the first to go online to the test network and use distributed verification (DVT) technology to provide upper-level customers with more decentralized technical solutions.

Special thanks:

Thanks to Frank, Junchen, web3 Navigator community for their inspiration and contribution to this article