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The Merge: everything you need to know about Ethereum's major update

The Merge: everything you need to know about Ethereum's major 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 number of questions.

This is it, we're here!

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 for two reasons:

  • No blockchain (at least of this size) has ever changed its consensus algorithm.
  • Ethereum has not undergone such a radical change since its creation in 2015.

The Merge, which is expected to take place around 14 September, is highly anticipated because it will enable 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-intensive.

The switch to PoS is not, however, without raising certain questions, particularly about security and decentralisation... To help you understand everything about Merge and its potential consequences, we've prepared a special report just for you.

1/ What is Proof-of-Stake?

There are currently two main consensus algorithms for cryptocurrencies. There is Proof-of-Work (PoW) and 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 carry out complex calculations and be rewarded in bitcoins according to the power they make available to the network (energy is proof that they are working). The more participants there are in the network, the more complex the calculations, and the more energy is needed!

The Proof-of-Stake works differently and consumes much less energy since there is no need to "mine". To take part in the network, you need to "validate" the blocks by proving that you own the network's cryptocurrency. In this case, ether.

To guarantee the security of the network, validators must "staker", 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 dreamed up 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 rely on a technology that had already been tried and tested.

"In the early days, there was a lack of hindsight on Proof-of-Stake consensus. The first ones like Tendermint and Tezos had barely been documented, so it was complicated to start with this consensus," rewinds Jérôme de Tychey, president of the Ethereum France association and organiser of the EthCC, one of the world's biggest ecosystem events.

But from the outset, Vitalik Buterin and the Ethereum team had explained that the PoW was just one 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 Jérôme de Tychey. And that day has now arrived.

3/ To what can we attribute The Merge's repeated delays?

According to the initial roadmap, the switch to Proof-of-Stake was supposed to take place in 2017, i.e... five years ago! What has happened to explain this delay? Quite simply because making such an update is anything but straightforward. "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 Ethereum's decentralisation over the long term," he adds.

Failing to reach a consensus among Ethereum developers, Merge has been postponed several times. The paradox is that many less energy-intensive "competitors" such as 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% 🤔.

4/ Will the network be paused for The Merge?

This is one of the points that fuels the most fantasy, so let's be clear! NO, the network will not stop spinning. 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 engines mid-flight. To ensure there are no accidents, Ethereum has been flying for almost two years with two engines switched on - one running on PoW and the other on PoS. The Merge consists of disconnecting the PoW engine and replacing it with the one running on PoS.

5/ Is there no risk at the time of the merge?

While 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 are using," concedes Barnabé Monnot, a researcher with the Ethereum Foundation. The real risk is that a third of 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 divides the industry the most.

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

First on "financial" security:

To take control of a blockchain, whether Bitcoin or Ethereum, attackers need to master the network.

  • For Proof-of-Work, you need to control the majority of the computing power produced by miners.
  • For Proof-of-Stake, 66% of the ethers immobilised in the protocol must be controlled.

Based on this system, an attack on the new Ethereum network would be at least as expensive as Bitcoin's ($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 thus be necessary to raise more than $40 billion to take control of Ethereum... "From an economic point of view, Ethereum is the most secure network," believes Abdelhamid Bakhta, an Ethereum developer who also claims to be a supporter of Bitcoin and 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 you can easily "detect aggressive behaviour by validators", explains Abdelhamid Bakhta. How can we do this? By spotting upstream those who are staking more and more ethers and getting closer to a controlling minority, or even majority.

The Proof-of-Stake - but this is also what has earned it fierce criticism - would potentially make it possible to exclude certain validators, and even those who have control of the network!

7/ Does Proof-of-Stake threaten Ethereum's decentralisation?

Here too the debate is not clear-cut. What is decentralisation? "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 decentralised with Merge," explains Jérôme de Tychey.

Since being a validator does not imply owning mining equipment - which can be very expensive - there should be more and more validators. The fact that, unlike mining, all validators benefit from the same return should also encourage more and more people to contribute to the network.

Big downside though: becoming a validator requires having a lot of ethers. A validator must immobilise 32 ethers 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!

"Let's not kid ourselves: as the price of ether rises, becoming a validator will become increasingly 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, which play the role of "super validator", allow anyone to place small quantities of ethers. As a sign of the vitality of this system, 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 the carbon footprint of Ethereum 2.0 be?

When miners are disconnected from the network, only the small computers of validators will count towards Ethereum's carbon footprint. And when we say "small", we really mean "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.

Remember, however, that validators will still have to use cloud services, such as Amazon Web Services or Infura. Even if it's not 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 the way it operates was not compatible with their commitments to sustainable development (CSR). "The energy dimension has always been a real issue for businesses," says Jérôme de Tychey. But will all businesses be interested in Ethereum overnight? We'll see in the coming months.

9/ Will transaction fees fall?

The other point that has earned Ethereum a fair amount of criticism concerns transaction fees.

It's no secret that at every peak in Ethereum usage, transaction fees tend to explode. In 2021, they may have exceeded €50 per transaction...

The reason we bring this up is that 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 transactions, on the other hand, will increasingly be handled by the secondary layers (layer 2) that connect to the main network.

At present, a transaction on a layer 2 such as Arbitrum and Optimism (there are also sidechains 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 "staked" ethers be able to be withdrawn?

Since December 2020, 420.000 addresses have deposited more than 14 million ethers, representing more than 20 billion euros.

From the outset, it was planned that the funds would be frozen until a date after the Merge. Their release could take place in early 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, have received staking revenue. These are 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% a year, but this return will fall mechanically as the number of validators increases," explains Jérôme de Tychey. However, the possible rise in the price of ether could compensate for this loss of return.

12/ What 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 immobilising ethers, unlike those available on exchange platforms, which can find takers at any time.

In addition, the Merge plans to considerably 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, money creation will be 166,000 new tokens per year. And if 100 million are locked in, creation will "only" reach 1.66 million ethers.

It should also be borne in mind that EIP 1559 implemented in August 2021 burns through 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 to force 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 their earnings," Abdelhamid Bakhta points out.

13/ What impact on decentralised finance (DeFi)?

The return offered to validators could gradually establish itself as a benchmark 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 decentralised exchanges such as Uniswap. "After The Merge, 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 from protocols specialising in outsourced staking, such as Lido, Stakewise or Rocket Pool," he murmurs.

14/ What will become of Ethereum miners?

A large proportion 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 outlets," insists Jérôme de Tychey, who is also co-founder of Cometh, a blockchain-based video game studio.

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