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The Merge: everything you need to know about Ethereum's big update
After years of development, Ethereum is about to change its consensus algorithm from Proof-of-Work to Proof-of-Stake. A "revolution" that raises a lot of questions.
This is it, we are there!
After years of development, Ethereum, the second largest blockchain on the planet, is about to change its consensus algorithm from Proof-of-Work to Proof-of-Stake.
This change, dubbed "The Merge", is a historic event in two ways:
- No blockchain (at least of this size) has ever changed its consensus algorithm.
- Ethereum has not seen such a radical change since its inception in 2015.
The Merge, which is expected to take place around 14 September, is highly anticipated because it will allow Ethereum to significantly reduce its carbon footprint.
How? By switching to Proof-of-Stake, which does not require cryptos to be mined (we explain everything below). Instead of miners, there will be validators whose activity is much less energy consuming.
However, the switch to PoS is not without questions, especially on security and decentralization... To help you understand everything about Merge and its potential consequences, we have prepared a special report.
1/ What is Proof-of-Stake?
There are two main consensus algorithms for cryptocurrencies today. There is the Proof-of-Work (PoW) and the Proof-of-Stake (PoS).
Used by Bitcoin, and Ethereum for a few more days, PoW is based on a fairly simple system: mining. To produce a block and record transactions on the blockchain, miners, who use computers, will perform complex calculations and be rewarded in bitcoins according to the power they make available to the network (energy is the proof that they are working). The more participants in the network, the more complex the calculations, and the more energy is needed!
Proof-of-Stake works differently and uses much less energy as there is no need to "mine". To participate in the network, you have to "validate" the blocks by proving that you have the network's cryptocurrency. In this case ether.
In order to guarantee the security of the network, the validators must "stake", i.e. immobilise cryptos. Those who try to cheat lose their immobilised capital. Those who play the game and secure the network are rewarded with newly created cryptos.
2/ Why didn't Ethereum opt for Proof-of-Stake from the start?
Ethereum was conceived in 2014 and launched in 2015. At the time, there was only one other major cryptocurrency, bitcoin, and it worked with Proof-of-Work. So it was a no-brainer for Ethereum's designers to build on an already proven technology.
"In the beginning, there was a lack of insight into Proof-of-Stake consensus. The first ones, like Tendermint and Tezos, had barely been documented, so it was complicated to start with this consensus," says Jérôme de Tychey, president of the Ethereum France association and organiser of the EthCC, one of the largest global events in the ecosystem.
But from the start, Vitalik Buterin and the Ethereum team had explained that the PoW was just a step before the transition to the PoS. "It was obvious that the Proof-of-Work would one day be discarded because of its energy consumption," adds Jérôme de Tychey. And that day has now arrived.
3/ To what can we attribute the repeated delays of The Merge?
According to the initial roadmap, the switch to Proof-of-Stake was supposed to take place in 2017, i.e.... five years ago! What happened to explain such a delay? Quite simply because making such an upgrade is anything but simple. "Designing a good proof of stake is a real challenge," explains Jérôme de Tychey. "Not all proofs are equal and we had to guarantee the decentralisation of Ethereum in the long term," he adds.
Due to a lack of consensus among Ethereum developers, the Merge has been postponed several times. The paradox is that many "competitors", less energy intensive like Tron, BNB Chain, Avalanche, Solana and others have taken advantage of this to launch and take a share of the market.
According to analytics site DeFi Llama, Ethereum and its ecosystem account for 64% of decentralised finance activity; by early 2021, it was 97% 🤔.
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4/ Will the network be paused for The Merge?
This is one of the most fantasized points, so let's be clear! NO, the network will not be paused. And for a simple reason: Ethereum's Proof-of-Stake has been running in parallel with Proof-of-Work since December 2020. So there will be no need to "install" it on D-Day.
Ethereum is like a plane that wants to change its engine in mid-flight. In order to avoid accidents, Ethereum has been flying for almost two years with two engines on - one running on PoW and the other on PoS. The Merge consists of disconnecting the PoW engine and replacing it with the PoS engine.
5/ Is there no risk at the time of the merge?
Although there is no absolute guarantee, the latest tests have in any case been conclusive. "But it is possible that some validators will fail to connect to the new chain depending on the software they use," concedes Barnabé Monnot, a researcher at the Ethereum Foundation. The real risk is that a third of the validators will fail to connect, which could limit the security of the blocks...
6/ Is Proof-of-Stake as secure as Proof-of-Work?
This is undoubtedly the question that most divides the players in the sector.
While PoW seems to be the most secure system today - Bitcoin has never been hacked in 13 years - PoS does have some interesting characteristics.
First of all, there is the "financial" security:
To take control of a blockchain, be it Bitcoin or Ethereum, attackers need to master the network.
- For Proof-of-Work, they need to control the majority of the computing power produced by the miners.
- For Proof-of-Stake, one must control 66% of the ethers locked up in the protocol.
Based on this system, an attack on the new Ethereum network would be at least as costly as Bitcoin ($14 billion).
It would be even more expensive as the price of the ether rises. In November 2021, when the ether cost more than $4,000, it would have taken more than $40 billion to take control of Ethereum.... "From an economic point of view, Ethereum is the most secure network," says Abdelhamid Bakhta, an Ethereum developer who also claims to be an advocate of Bitcoin and the Proof-of-Work.
Following this logic, however, Ethereum's security is less important if the ether price starts to fall... "The advantage of PoW is that the source that secures the network (the mining machines) is not directly linked to the price of the asset," concedes Abdelhamid Bakhta.
Then there is the ability to identify attackers:
One of the big advantages of Proof-of-Stake is that it is easy "to detect aggressive behaviour by validators", explains Abdelhamid Bakhta. How do you do this? By spotting upstream those who stake more and more ethers and get closer to a minority, or even a controlling majority.
The Proof-of-Stake - but this is also what makes it highly critical - could potentially exclude certain validators, and even those who have control of the network!
7/ Does Proof-of-Stake threaten the decentralisation of Ethereum?
Here again the debate is not clear-cut. What is decentralisation ? "If it defines the number of individuals who will occupy the role of validators, we can anticipate that the new Ethereum will certainly be more decentralised with The Merge," explains Jérôme de Tychey.
Since being a validator does not imply owning mining equipment - sometimes very expensive - there should be more and more validators. The fact that, unlike mining, all validators enjoy the same return should also encourage more and more people to contribute to the network.
The downside is that becoming a validator requires a lot of ethers. A validator must have 32 ethers tied up in the protocol, which currently corresponds to $50,000. When the price peaked at the end of 2021, this represented 150,000 dollars... Being a validator is therefore not for everyone!
"We must not delude ourselves, as the price of ether rises, becoming a validator will become more and more expensive," concedes Jérôme de Tychey. For Barnabé Monnot, a researcher at the Ethereum Foundation, the 32-ether threshold "is not set in stone and could be revised downwards".
In the meantime, players such as Lido, who play the role of "super validator", allow anyone to place small quantities of ethers. In a sign of the system's vitality, Lido is currently the biggest validator with 31% of Ethereum staking, followed by Coinbase (15%) and Kraken (8%), according to data from Dune Analytics. The top individual validator is Ethereum creator Vitalik Buterin (0.05%).
8/ What will be the carbon footprint of Ethereum 2.0?
When miners are disconnected from the network, only the small computers of the validators will be counted in the carbon footprint of Ethereum. And when we say "small", we really mean "small": you will even be able to use a Raspberry Pi, a computer the size of a credit card that sells for less than 100 euros.
But remember that validators will still have to use cloud services, like Amazon Web Services or Infura. Although it may not be obvious at first glance, data centres have a significant environmental impact.
In recent years, many large companies have shunned the crypto sector (and Ethereum in particular) because its operation was not compatible with their commitments to sustainable development (CSR). "The energy dimension has always been a real issue for companies," says Jérôme de Tychey. But will all companies become interested in Ethereum overnight? This is what we will see in the next few months.
9/ Will transaction costs fall?
The other point that has earned Ethereum a lot of criticism concerns transaction fees.
It's no secret that at every peak in Ethereum usage, transaction fees tend to explode. In 2021, they could exceed 50 euros per transaction...
If we mention this point, it's because some people have explained that The Merge would make transactions cheaper. However, and at the risk of disappointing some, this will not be the case!
Ethereum is increasingly a protocol reserved for very large transactions (layer 1), like interbank flows in traditional finance.
Smaller, everyday transactions will increasingly be handled by the secondary layers (layer 2) that connect to the main network.
Currently, a transaction on a layer 2 such as Arbitrum and Optimism (there are also side chains such as Polygon) rarely exceeds a few cents. "They cost between 5 and 40 times less than the main chain," notes Jérôme de Tychey. And these should continue to improve over the next few years (see box below).
10/ When will the staked ethers be withdrawn?
Since December 2020, 420,000 addresses have deposited more than 14 million ethers, which represents more than 20 billion euros.
From the outset, it was planned that the funds would be blocked until after the Merge. Their release could take place at the beginning of 2023 "in the most optimistic scenario", says Barnabé Monnot.
This delay is explained by the desire to avoid a possible flight of validators on the day of the Merge. "We need a few months to see how the network behaves," says Jérôme de Tychey. A "release" date for staked ethers will then be set by the community.
11/ How much will validators be paid?
Since December 2020, validators, who secure the network, receive staking revenues. This is currently 4.2% over one year. From next week, validators will also receive part of the transaction fees paid by network users 💰.
"Validators will therefore be able to earn between 8% and 9% per year, but this return will mechanically fall as the number of validators increases," explains Jérôme de Tychey. The possible rise in the ether price could, however, compensate for this loss of return.
12/ What are the consequences for the price of ether?
One of the main consequences of the Merge could be to increase the price of ether. Why? Because staking involves tying up ethers, unlike those available on exchange platforms which can find takers at any time.
In addition, the Merge plans to significantly reduce Ethereum's currency creation.
Currently, 5 million ethers are created each year. According to Vitalik Buterin, if 1 million ethers are locked into the new Ethereum, the money creation will be 166,000 new tokens per year. And if 100 million are locked in, the creation will "only" reach 1.66 million ethers.
It should also be borne in mind that the EIP 1559 implemented in August 2021 burns a part of the transaction fees, which also contributes to limiting the supply in circulation, even making the ether deflationary at times.
Finally, validators have no fixed costs. "There is nothing that forces them to sell their ethers, whereas in Proof-of-Work miners have recurring costs (such as their electricity bills) that prevent them from keeping all of their earnings," stresses Abdelhamid Bakhta.
13/ What impact on decentralised finance (DeFi)?
The return offered to validators could gradually become a reference rate for ether. Each DeFi service or application that offers to invest ethers will have to offer at least an equivalent return to remain attractive.
This reference rate should also upset the balance on decentralised exchanges like Uniswap. "After The Merge, the liquidity pools containing ethers should move strongly in one direction or the other," Jérôme de Tychey anticipates. "This could also have an influence on the price of governance tokens of protocols specialising in staking subcontracting, such as Lido, Stakewise or Rocket Pool," he says.
14/ What will happen to Ethereum miners?
A large part of these miners should allocate their computing power to other protocols that continue to use Proof-of-Work (Ethereum Classic for example). They will also be able to rent their power on the iExec blockchain network (developed on Ethereum) to projects that need it.
"The metaverse sector should also need significant capacity, so there is no shortage of opportunities," insists Jérôme de Tychey, who is also co-founder of Cometh, a video game studio on blockchain.
Before investing in any product, investors should fully understand the risks involved and consult their own legal, tax, financial and accounting advisors.
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