This is it, we're there!

After years of development, Ethereum, which is the second largest blockchain on the planet, is about to change its consensus algorithm from Proof-of-Work to Proof-of-Stake.

This development, dubbed "The Merge," is a historic event in two ways:

• No blockchain (at least of this size) has ever changed its consensus algorithm.

• Ethereum hasn't seen such a dramatic change since its inception in 2015.

The Merge, which is expected to take place around September 14, is highly anticipated because it will allow Ethereum to significantly reduce its carbon footprint.

How do you do that? By switching to Proof-of-Stake which does not require mining cryptos (we explain everything below). Instead of miners, there will be validators whose activity is much less energy consuming.

However, the transition 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.

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1/ What is the 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 operations on the blockchain, miners, who use computers, will perform complex calculations and be rewarded in bitcoins according to the power they put at the disposal of the network (the energy is the proof that they work). The more participants there are in the network, the more complex the calculations are, and the more energy is needed!

Proof-of-Stake works differently and uses much less energy since 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. immobilize cryptos. Those who would try to cheat lose their immobilized capital. Those who play the game and secure the network are rewarded with newly created cryptos.

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2/ Why didn't Ethereum opt for the Proof-of-Stake from the start?

Ethereum was dreamed up in 2014 and launched in 2015. At the time, there was only one other major cryptocurrency, bitcoin, and it ran on Proof-of-Work. So it was a no-brainer for Ethereum's designers to build on an already proven technology.

"At the beginning, we lacked hindsight on the Proof-of-Stake consensus. The first ones like Tendermint and Tezos had just been documented, it was complicated to start with this consensus," rewinds Jerome de Tychey, president of the Ethereum France association and organizer of the EthCC, one of the biggest global events of the ecosystem.

But from the start, Vitalik Buterin and the Ethereum team had explained that the PoW was only a step before the transition to PoS. "It was obvious that the Proof-of-Work would one day be discarded because of its energy consumption," adds Jérôme de Jérôme de Tychey. And that day has now arrived.

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3/ To what can we attribute the repeated delays of The Merge?

According to the original roadmap, the transition to Proof-of-Stake was supposed to take place in 2017, that is... five years ago! What happened to explain such a delay? 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 of them are equal and we had to guarantee the decentralization of Ethereum in the long term," he adds.

Due to a lack of consensus among Ethereum developers, Merge has been pushed back several times. The paradox is that many "competitors", less energy-consuming as Tron, BNB Chain, Avalanche, Solana and others have taken the opportunity to launch and take a share of the market.

According to analytics site DeFi Llama, Ethereum and its ecosystem account for 64% of decentralized 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 about issues, so let's be clear! NO, the network will not stop running. 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 an airplane that wants to change its engine in mid-flight. 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.

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5/ Isn't there a risk at the time of the merger?

While there is no absolute guarantee, the latest tests have in any case been conclusive. "But it is possible that some validators fail to connect to the new chain depending on the software they use," concedes Barnabé Monnot, 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 the Proof-of-Stake as secure as the Proof-of-Work?

This is probably the most divisive issue in the industry.

While PoW seems to be the most secure system today - Bitcoin has never been hacked in 13 years - PoS has some interesting features.

First, on "financial" security:

To take control of a blockchain, whether it's Bitcoin or Ethereum, attackers must master the network.

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• For the Proof-of-Work, you need to control the majority of the computing power produced by the miners.

• For the Proof-of-Stake, 66% of the ethers immobilized in the protocol must be controlled.

Based on this system, an attack on the new Ethereum network would be at least as costly as Bitcoin ($14 billion).

It would even be more expensive as the price of ether progresses. In November 2021, when the ether cost more than 4000 dollars, it would be necessary to mobilize more than 40 billion dollars to take control of Ethereum... "From an economic point of view, Ethereum is the most secure network", estimates Abdelhamid Bakhta, an Ethereum developer who also claims to be a supporter of Bitcoin and Proof-of-Work.

Following this logic, however, the security of Ethereum is less important if the price of ether 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 we can easily "detect aggressive behavior from validators," explains Abdelhamid Bakhta. How can we do this? By spotting upstream those who stall more and more ethers and get closer to a minority or even a majority of control.

The Proof-of-Stake - but this is also what makes it highly criticized - could potentially exclude some validators, and even those who have control of the network!

7/ Does the Proof-of-Stake threaten the decentralization of Ethereum?

Here again the debate is not clear-cut. What is decentralization? "If this defines the number of individuals who will occupy the role of validators, we can anticipate that the new Ethereum will certainly be more decentralized with Merge," explains Jérôme de Tychey.

Since being a validator does not require 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.

A big drawback, however, is that becoming a validator requires a lot of ethers. A validator must immobilize 32 ethers in the protocol, which currently corresponds to 50,000 dollars. When the price was at its highest at the end of 2021, this represented 150,000 dollars... Being a validator is therefore not for everyone!

"We must not delude ourselves, with the progression of the price of the ether become validator will become increasingly expensive," concedes Jerome de Tychey. For Barnabé Monnot, researcher at the Ethereum Foundation, the threshold of 32 ethers "is not set in stone and it could be revised downwards.

In the meantime, players like Lido, who play the role of "super validator", allow anyone to place small amounts of ethers. A sign of the vitality of this system, Lido is currently the biggest validator with 31% of Ethereum's 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 Ethereum's carbon footprint. And when we say "small", we mean really "small": you'll even be able to use a Raspberry Pi, a computer the size of a credit card that sells for less than 100 euros.

Remember, however, that validators will still need to use cloud services, such as Amazon Web Services or Infura. Although it may not be obvious at first glance, data centers have a significant environmental impact.

In recent years, many large companies were shunning 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? We'll see in the coming months.

9/ Will transaction fees drop?

The other point that earns Ethereum quite a bit of criticism is the transaction fees.

It's no secret that at each 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 may 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), similar to interbank flows in traditional finance.

Small day-to-day operations will be increasingly handled by the secondary layers (layer 2) that connect to the main network.

Currently, a transaction on a layer 2 like Arbitrum and Optimism (there are also sidechains like Polygon) rarely exceeds a few cents. "They cost between 5 and 40 times less than the main chain," notes Jérôme de Tychey. And they should continue to improve in the coming years (see box below).

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10/ When can the stashed 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 leak of validators on the day of the Merge. "We need a few months to see how the network behaves," says Jérôme de Tychey. A date for the "release" of stashed ethers will then be set by the community.

11/ How much will validators be paid?

Since December 2020, validators, who secure the network, have been receiving staking revenues. These are currently 4.2% year-on-year. Starting next week, validators will also receive a portion 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 decrease as the number of validators increases," explains Jérôme de Tychey. The possible rise in the price of ether could however compensate for this loss of return.

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12/ What are the consequences for the price of ether?

One of the main consequences of the Merge could be to drive up the price of ether. Why? Because staking involves tying up ethers, as opposed to those available on exchange platforms that can find takers at any time.

In addition, the Merge plans to significantly reduce Ethereum's money creation.

Currently, 5 million ethers are created each year. According to Vitalik Buterin, if 1 million ethers are locked into the new Ethereum, the monetary 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 kept in mind that the EIP 1559 implemented in August 2021 burns some of the transaction fees, which also helps to limit the supply in circulation, even making 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," emphasizes Abdelhamid Bakhta.

13/ What impact on decentralized finance (DeFi)?

The yield offered to validators could progressively impose itself as a reference rate for ether. Every DeFi service or application that offers to place ethers will have to offer at least an equivalent yield to continue to be attractive.

This reference rate should also upset the balance in force on decentralized 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 specialized in staking outsourcing, such as Lido, Stakewise or Rocket Pool", he blows.

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 is also expected to need significant capacity, so there is no shortage of opportunities," insists Jérôme de Tychey, who is also co-founder of Cometh, a blockchain-based video game studio.

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