The Merge: what to expect from the largest Ethereum update

A few months are left before the long-awaited update of The Merge, which will be an important milestone in the development of Ethereum. Not only will the consensus algorithm change — ether will become more environmentally friendly and deflationary, which can have a positive impact on its price in the medium and long term.

We figured out the features of the upcoming upgrade and its potential impact on the investment attractiveness of the second largest cryptocurrency by capitalization.

• The last preparations remained for Ethereum's transition to the Proof-of-Stake consensus algorithm during the activation of The Merge update.
• The upgrade will significantly affect the fundamental qualities of the cryptocurrency, making it deflationary and much more environmentally friendly.
• The rate of ether emission affecting the price will depend on the number of validators and on-chain activity.

From inflation to deflation

Currently, most of the new Ethereum emission takes place in the traditional PoW-blockchain — execution level. Miners receive 2 ETH per block mined — a total of more than 12,000 ETH per day.

A small part of ETH is issued on the Beacon Chain. This PoS-based network is called the consensus level.

The launch of the Beacon Chain (or the zero phase of the second version of Ethereum) took place on December 1, 2020.

The number of ETH issued at the consensus level varies depending on the number of validators and the volume of coins in the betting. Another factor affecting the issue is the burning of part of the transaction fees, depending on the network load. This mechanism (EIP-1559) was activated in Hartford London, since which more than 2.4 million ETH have been burned.

With the current 12.7 million ETH in staking (about 10% of the market supply of ether) and a daily burning rate of 7,900 ETH, inflation will be 2.1%. In other words, the annual volume of the new issue will be approximately 5.4 million ETH.

The following screenshot is a heat map. It shows how changes in the burning rates and volumes of stacked ETH at the consensus level affect the daily volume of Ethereum emissions.

After The Merge is activated, the issue mechanism no longer assumes a fixed reward for miners per block. The amount of ETH in the form of a reward to validators will change dynamically, epoch epoch lasting 6.4 minutes.

Suppose 11 million ETH is involved at the consensus level. The heat map above shows that with this parameter, 1511 ETH will be issued per day.

If we take into account the burning of coins — for example, 4000 ETH per day — Ethereum will become deflationary. The volume of supply with such parameters will decrease by 2,489 ETH per day or by 0.77% per year.

The amount of ETH burned directly depends on on chain activity, which, after the completion of the hype around DeFi and TAI, goes into decline. The graph below shows that in relation to the peak levels of May 2021, the number of transactions in the Ethereum network has significantly decreased. The daily figure is below the 1 million mark, which corresponds to the values of the beginning of 2018.

"If the adoption of Ethereum by users goes up in the coming months and years after the Merge upgrade, the ether supply will decrease even faster," — Galaxy Digital Research experts.

Then, according to them, the value proposition of the second largest cryptocurrency will increase, especially in the context of a means of preserving value.

As already mentioned, the security of the PoS network is provided not by energy-intensive miners, but by validators who block the provision in the form of ETH in the network. The more coins there are in the staking, the more difficult it is for a potential attacker to gain control of the system and change the transaction history.

The Ethereum consensus level is created in such a way that rewards to validators are automatically adjusted depending on the amount of ether involved.

When the amount of ETH in the stake grows and a lot of validators are actively working on the network, the profitability of the latter decreases. In the opposite situation, when there are few validators and coins in staking, profitability increases to encourage their more active participation in the network.

As of 06/8/2022, there are 399,554 validators.

The algorithmically changing rate of emission ensures that, regardless of the amount of ETH in the stack, validators are always sufficiently motivated to work.

"However, such a dynamic approach is fraught with difficulties when it comes to forecasting Ethereum's monetary policy for the long term," — Galaxy Digital Research experts stressed.

In addition to the number of ETH in stacking and the number of coins burned, analysts should also take into account less significant indicators: online validators and slashed ones.

The graph above illustrates the projected decline in ETH supply after The Merge is activated. According to the Ultra Sound Money service, when burning 2.9 million ETH per year (or about 8000 ETH per day, which is the average since the activation of EIP-1559), the number of coins in circulation will decrease by 2% per year.

Other factors will also affect the income structure:

• The priority fees that Ethereum miners currently receive will be paid to active validators after The Merge is activated. According to Coin Metrics, the total amount of such "tips" is just over 1000 ETH per day and about the same amount is the daily income of validators. Consequently, the income of the latter will double.
  In addition to the "tip", validators will receive the Maximum Extractable Value (MEV). Flashboot researcher Alex Obadiah estimated that the proceeds from MEV can increase their income by 75%.

Liquid staking and centralization risks

An increasing share in the Beacon Chain is accounted for by platforms operating under the Staking-as-a-Service (SaaS) model. The undoubted leader in this segment is the liquid staking service Lido.

The diagram below shows that large exchanges also have significant weight: Kraken, Binance and Huobi.

The popularity of SaaS providers is largely due to the fact that such platforms greatly simplify and democratize staking thanks to the possibility of delegation. Users do not need to have 32 ETH — you can use small amounts. Deep technical knowledge is also not required.

In addition, many SaaS providers offer users the possibility of insuring losses from slashing. Liquid staking services also help to increase capital efficiency — for example, Lido issues derivative tokens representing funds blocked in a staking contract. Such coins can be used in DeFi protocols to generate additional income.

"Given the higher profitability of ETH derivatives over ETH itself, tokens like rETH and stETH may at some point become competitors and even surpass ether in the context of liquidity and adoption as the main currency for DeFi operations," Galaxy Digital Research representatives shared their thoughts.

The graph below shows that Lido is ahead of competitors in its segment by a large margin.

Bankless co-founder Ryan Sean Adams admitted that over time ETH will become something like perpetual Internet bonds, the holders of which will simultaneously be creditors and owners of the network. Thus, ether, as the underlying asset, will be less and less involved in dapps.

Given the wide range of interesting options from SaaS providers, we can expect further growth in their popularity and, consequently, the value of assets under management (TVL).

There is a trend towards decentralization in the segment. For example, Lido is implementing distributed validator technology. A newer service, Rocketpool, is gradually gaining momentum, positioning itself as a decentralized staking platform.

When The Merge will be activated?

Testing of The Merge is in full swing: on June 8, Ethereum developers transferred the Ropsten network to PoS. Within a few weeks, the transition of the Goerli and Sepoila testnet is expected.

In May 2022, one of the leading developers, Preston Van Loon, announced that Meinert's transition to PoS would take place in August. Vitalik Buterin also called the last month of summer the most likely date, but allowed the postponement of the event to September-October in case of "potential risks".

According to conservative scenarios from Massari, The Merge will be activated in November-December at all.

Analysts expressed confidence that after the upgrade, Ethereum will no longer be perceived as a "utopian experiment". On the contrary, cryptocurrency will attract long-term investors.

Messari assumed that the staking reward would be in the range of 7%-13%.

Future development

After the Merge activation, the Shanghai hard fork will be an important event. It caused an increase in the scalability of the network, to make available the withdrawal of stacked funds, to modernize the Ethereum virtual machine (EVM).

In March, Vitalik Buterin shared the idea of Proto-danksharding-a scenario of transaction-oriented data checks, rushing so-called blobs that cannot pop up on EVM.

Proto-danksharding is intended to replace danksharding, a deletion method in which only one proposal author selects all transactions and data that fall into a certain slot. This approach was introduced in February 2022 by Ethereum Foundation researcher Dankrad Fast.

The founder of Etherium proposed to automatically delete the data of a large binary object every Z0 days so that the network does not impose too high requirements for data storage and memory.

There is also an EIP-4488 aimed at the expanded use of Ethereum-based storage packages. Initially, this relatively simple solution was planned to be implemented before the Merge was activated. EIP-4488 reduces the cost of sending transaction packets from second-tier networks to the Ethereum blockchain by five times.

"Despite the fact that The Merge is the most difficult update in the history of Ethereum, this is not the last upgrade of the network," Galaxy Digital Research emphasized.

After that, the researchers are sure, the developers will focus on other pressing issues that have been developed for years, such as scalability and statelessness.

Galaxy Digital Research researchers have predicted other consequences of Ethereum's transition to PoS:

• The popularity of mining cryptocurrencies on the GPU will decrease. Some miners will switch to alternative coins like Ethereum Classic or Ravencoin. Many will simply sell video cards, which will then get to gamers and designers. This will reduce the prices of devices on the market and affect the incomes of manufacturers.
• Bitcoin, which remains the largest PoW cryptocurrency, will be even more criticized for the high energy intensity of the network.

Conclusions

According to optimistic forecasts, The Merge activation is expected in August. However, given the technical complexity of the merger process and the tendency of developers to postpone upgrades, this event may take place in the deep autumn.

One of the most significant consequences of switching to PoS will be the retirement of miners from the game. This can significantly affect market conditions in the short term. Most likely, the selling pressure will decrease, and the hashrates of altcoins like Ethereum Classic will grow.

In the medium and long term, Ethereum may become a more investment-attractive cryptocurrency. First, the project will prove its antifragility. Secondly, the asset will match the trend for environmental friendliness.

Finally, deflation will certainly do its job. However, its level will depend on the activity of users.

The Merge is far from the last important update of Ethereum. It will help to solve the scaling problem, where sharding and Rollups play a big role.