The Investor’s Guide to the Ethereum Merge

Recent changes to the ‘difficulty bomb’ have pushed back the estimated date of the Merge to September 2022. – update: July 6, 2022.

“If Ethereum fails to scale, then Ethereum definitely failed.” — Vitalik Buterin

Vitalik’s vision for Ethereum is clear: become a global decentralized programmable blockchain — that people use. However, to realize this vision, the network must solve the “blockchain trilemma” — scalability, decentralization and security. The Ethereum Merge aims to pave the way to scalability by laying an energy efficient proof-of-stake protocol as a decentralized and secure foundation.

In this article, we will take you through the mechanics of the Ethereum Merge, its motives, and why a successful implementation has a cascading impact on the entire industry. 

Let’s get started with what the Merge is.

What is the Ethereum Merge?

Previously referred to as ETH 2.0, the Ethereum Merge is a multi-year event designed to upgrade the blockchain from a proof-of-work to a proof-of-stake consensus mechanism. If the Merge is successful, Ethereum will transition to a more environmentally friendly and efficient protocol. But to better understand the motives of the Merge, we need to revisit the story of blockchain. 

First-generation blockchain technology such as bitcoin began with a simple objective: transact digital value without banks. Through the innovation of smart contracts, Ethereum expanded the power of decentralized consensus to enable a wide array of applications in areas such as healthcare, gaming and Web3. Through this shift, the vision of blockchain grew from a financial operating system to a societal one.

However, as the demand for Ethereum grew, Ethereum’s core architecture started to show signs of congestion — sometimes causing gas fees of $500 per transaction and consuming as much energy as a small country. These cost limitations prevent the adoption needed for it to provide decentralized solutions at a societal scale. 

How does proof-of-stake help Ethereum?

Proof-of-stake (PoS) does not immediately solve high gas fees, but it helps Ethereum reduce its energy usage to that of a small town. It is the critical next step toward global scalability. And here’s how.

PoS, like its predecessor proof-of-work (PoW), is a consensus mechanism — in other words, it’s how the network agrees on what’s true. With Ethereum, “truth” can be anything from a simple transaction to complex clauses of a smart contract. 

For all participants in a network to behave appropriately, the mechanism needs rules and rewards, just like a game. And to prevent cheating, the mechanism must require participants to stake something of value. 

For PoW, that requirement is expensive energy and equipment. In contrast, PoS requires participants to stake temporarily locked funds in the mechanism. Removing the energy requirement allows Ethereum to scale to global proportions. 

To better understand the pros and cons of both protocols, read our complete guide on proof-of-work vs. proof-of-stake. 

The Beacon Chain: Phase 0 of the ETH Merge 

Switching to PoS isn’t as easy as pressing a button. The Ethereum development team has been working on the transition since 2016 and has called off the switch multiple times. An enormous Web3 ecosystem of business decentralized apps, decentralized exchanges and NFT (non-fungible token) marketplaces depend on an error-free transition.

So on Dec. 1, 2020, the team launched the Beacon Chain — phase 0 of a slow and cautious merge. As the name suggests, the Beacon Chain is a parallel PoS side chain to Ethereum’s existing PoW blockchain — often referred to as the Ethereum mainnet. It does not impact users or apps on the main chain or support smart contracts but rather serves as a record keeper of all transactions. Think of the new chain as a relay runner. It is waiting for its turn to take the baton but needs to be running at the same speed before the official handoff.

This side chain uses a one-way bridge smart contract. It enables users to stake or delegate their ETH to a Beacon Chain validator address but prevents them from withdrawing funds or rewards. Users will likely be able to withdraw after the two post-merge updates Shanghai and Capella, which could happen by the end of this year.

To learn more about the mechanics of staking, check out our complete guide.

Why validator and client diversity is essential 

With over 9 million ETH staked on the Beacon Chain, a successful merge depends on the blockchain having a diverse set of validators and clients. Think of validators as game participants and clients as their operating system. If each player uses the same operating system and encounters a bug in one of its updates, the entire game shuts down. And if one player gets too powerful, it can hijack the game and alter the reward amounts in their favor.  

In the proof-of-stake game, any player can use various cheating tactics if they own a significant percentage of the stake (50% pre-merge, 66% post merge). So say there are only two clients and nine validators. Six validators are on client A, and three are on client B. If client B goes down, the network is at greater risk of a malicious attack since it is easier for a single validator to increase their total share of the stake. If client A were to go down in a post merge scenario, network consensus would be impossible — resulting in something called an inactivity leak.

Validators can reduce this risk by running minority clients. Figment, an institutional staking service, emphasized this point in a recent insider report. They outlined some of the current vulnerabilities approaching the Merge and stated.

“Client diversity is the responsibility of all stakeholders — not just the larger ones. But in the short to medium term, convincing larger entities to diversify their clients will have the greatest impact.”

But client diversity doesn’t only benefit the network. Figment explains that should a validator be running a majority client with a bug that goes offline, that validator along with all other validators running that client will face elevated downtime penalties (i.e., inactivity leak). By running a minority client, validators avoid these heightened downtime penalties.

Merging the Beacon Chain and mainnet via testnets

Ethereum testnets are blockchains that simulate the Ethereum mainnet but have lower mining complexity and testnet ETH fees. Once there are enough successful testnet merges, the core team will schedule the merge of Ethereum mainnet and the Beacon Chain. 

However, this procedure doesn’t turn off proof-of-work with a flip of a switch. Ethereum.org states that the Merge will effectively make the Beacon Chain its own proof-of-stake shard. This alone leaves a theoretical window where miners could continue a proof-of-work fork on Eth1 client(s).

To address this, the core team created a solution to freeze PoW. They call it the difficulty bomb, and it is the most contentious element of the Merge.

What is the difficulty bomb, and how will it freeze proof-of-work on Ethereum?

The difficulty bomb is code developed in 2016 that rapidly increases the difficulty to mine a block on Ethereum, eventually making it economically infeasible to mine ETH using the PoW protocol. If the developer community times it just right, it will incentivize miners to abandon PoW.

The only problem is that the community can’t agree on the timing. Strong proof-of-stake advocates believe they should deploy the difficulty bomb early to expedite the Merge, and others think that will push the developer team too fast, increasing the chance of mistakes. Core developers have delayed the difficulty five times, citing PoS and mainnet merge concerns as the main reason. 

When will the Merge happen?

After the merge of Ropsten and Ropsten Beacon chain on June 8 2022, the mainnet Merge date seems to be inching closer. However, the Ethereum foundation hasn’t committed to any definite timelines. Based on current estimates, the Merge is likely to happen sometime in Q3 of 2022. 

What will happen after the Merge?

If transaction volumes continue at current rates, ETH is expected to offer a better yield to its stakers. According to Coinshares, the base APY number seems to fluctuate between 8% and 12%.

Additionally, the functionality to withdraw staked ETH is not scheduled to go live along with the Merge. Instead, developers will focus on features such as these in the “post-merge” period, which does not have a definite timeline.

How Ethereum will use sharding to scale 

After the post-Merge period, the development team will start on the next phase of Ethereum’s scheduled transition — sharding. Even though the Merge is a positive development for the entire network, transaction fees still deter network adoption. Sharding is the second step to this solution.

As Vitalik outlines, sharding allows blockchains to scale vertically. Instead of transactions queuing up on a single blockchain and causing network congestion, the consensus layer will manage 64 blockchains, otherwise known as shards. In time, the main Ethereum blockchain we use today will be one of the 64 shards.

Why is the Ethereum merge so important?

With newer blockchains such as Solana and Avalanche trying to siphon Ethereum’s market share, Ethereum’s scalability problem is an existential risk. Although Ethereum currently has a network effect and a vast community on its side, it needs to address these problems to retain them. 

The Merge is estimated to reduce energy consumption by 99.5% alongside a 90% drop in issuance of the ETH tokens. Thus, many expect the demand for the ETH token to rise, which is good news for ETH investors. Additionally, PoW validators would need to switch from investing in expensive GPUs to holding an Ethereum stake, adding even more demand.

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This content is sponsored by Figment.

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