The Ethereum (ETH) Merge is upon us this September. It is the second phase in Ethereum 2.0 (or ETH2) – a multi-phase upgrade that attempts to improve the Ethereum network's scalability and security by making infrastructure modifications, specifically moving from a Proof-of-Work (PoW) consensus mechanism to a Proof-of-Stake (PoS) consensus mechanism.
Beacon Chain, phase 1 of the upgrade launched in December 2020, is the component responsible for controlling PoS and will merge with Ethereum 1.0 – referred to as the "execution layer," where network and smart contract (a programmable self-executing contract) rules reside.
Since this is an upgrade rather than a new network built from scratch, Ethereum will continue as a single network after the Merge. In essence, the entire Ethereum PoW chain becomes the Ethereum PoS chain. The Merge will not affect the data layer of Ethereum, so no transactions will be lost in this transition.
However, because PoW mining will no longer be required, miners will likely stake their assets and help validate the Ethereum mainnet, the end-product of a blockchain project, which is accessible by the public to use.
Why the need for ETH 2.0 Staking?
The increased use of Ethereum 1.0 has made it difficult for the network to scale due to increased transactions fees and slower transaction times.
This is partly due to the success of decentralized finance (DeFi) projects – providing lending, borrowing, liquidity pools and trading services, where consumers are willing to pay high transaction fees due to the appealing rewards of these applications. But the increased adoption has become a double-edged sword, resulting in high network congestion, increasing transaction fees and slow transaction times.
Transaction fees, or “gas” fees, fund not only transactions but also actual decentralized applications (DApps) operating on the Ethereum blockchain.
To address these issues, the Ethereum Foundation has been working on a network upgrade that attempts to improve the security, speed, efficiency, and scalability of the Ethereum network. The Ethereum network’s security and scalability allow it to process more transactions, alleviate bottlenecks and accommodate more use cases, particularly outside of finance. By doing so, all DApps, including DeFi applications, will become more efficient and scalable.
A staking model will replace Ethereum's existing mining process as part of this upgrade. On a PoS blockchain, staking is the process of actively participating in transaction validation (similar to mining or PoW).
In contrast to PoW, which requires miners to compete for rewards based on the amount of computational power they can acquire, the proof-of-stake mechanism randomly selects validators relative to the total amount and time their ether currency has been staked.
Also unlike proof-of-work, PoS validators don't need to mine blocks to maintain the network. Instead, they need to create new blocks when chosen and validate others when not. Once a participant has validated the latest block of transactions, other contributors can attest the block is valid.
When enough attestations are made, the network adds a new block. Rewards are then distributed in ether by the network in proportion to each validator's stake. To incentivize good behavior and mitigate bad actors, there are also penalties that can cause validators to lose a portion (or even all) of their staked ETH if they fail to validate or attest to malicious transactions.
Anyone with the minimum necessary ETH balance can validate transactions and earn staking rewards. Ethereum can also be staked on cryptocurrency exchange platforms like Coinbase, Binance, Kraken, etc.
Currently, Ethereum 1.0 handles 15 transactions per second (TPS), which is relatively slow in the context of financial transactions. Visa, for example, processes about 1,736 TPS, while MasterCard processes 5,000 TPS. The Merge is expected to enable the processing of 100,000 TPS, far exceeding even conventional financial payments services, considerably expanding the breadth of projects and applications that can be built on the Ethereum blockchain.
How does staking work?
In a similar process to mining, staking involves users actively participating in transaction validation on the PoS blockchain. Any user that meets the minimum balance of a cryptocurrency can validate transactions in exchange for staking rewards. On Ethereum 2.0, 32 ETH are required to fully activate the validator software.
The PoS blockchain will bundle 32 blocks of transactions during each validation round. During the validation process, also known as "attesting," the Beacon Chain, which controls the staking, assigns groups of validators into "committees" of 128, who are then given a shard block ("Sharding" refers to splitting the entire Ethereum network into multiple portions called “shards”).
A base reward will determine the issuing rate of Ethereum 2.0. As the number of validators connected to Ethereum 2.0 increases, the lower the base reward will be per validator – the base reward is inversely proportional to the square root of the balance of Ethereum 2.0 validators.
Why stake ETH 2.0?
A primary reason you would want to stake ETH is to obtain the APR, or annual percentage rate, which can vary depending on amount staked. According to the Ethereum Foundation, the APR is currently averaging 4.1%. With the minimum need of 32 ETH, you may be rewarded about 1.3 ETH per year.
But it's not quite as easy as buying 32 ETH and collecting the interest.
You must “lock” your ETH until the Ethereum 2.0 protocol is released, which may take a couple of years due to constant delays. Staking Ethereum for Ethereum 2.0 will not be a realistic alternative for people who have liquidity concerns or do not have enough capital (as of this writing, 32 ETH amounts to over $51,080).
There are ways to stake without a validator node, which I'll discuss in a future article, but for now it's enough to stay that you can stake and get rewards by putting ETH (any amount) on an exchange or using other DeFi products.
Another reason someone would wish to stake Ether is to aid the network. Nodes, which are individual computers that have staked ETH and are functioning, must validate the network to be legitimate. Staking could be for you if you want to validate the network, increase its health and security, and gain a reasonable payout in the process.
The Merge: Market impact and value implications
Transitioning from the legacy Ethereum 1.0 system to a new upgraded Ethereum 2.0 system is very challenging and requires the meticulous work of auditing and debugging of any code issues. That is the reason why traditional financial institutions have often chosen the path of "if it ain’t broke, don’t fix it."
Merging Ethereum 1.0 with the Beacon Chain has a lot of moving parts and market impact on Ethereum. These software upgrades require rigorous testing from the community and core developers to mitigate any bugs or vulnerabilities. Several notable tests, upgrades, and forks have been done since the launch of the Beacon Chain in late 2020 as part of the transition to proof-of-stake.
The Ethereum blockchain has been a great success – the most used blockchain by far over all others. The Ethereum community has attracted brilliant minds, including app developers and core protocol developers. The upgrading of the core protocol is a tremendous undertaking that has been meticulously planned and implemented to date.
Other, newer blockchains are gradually eroding some of Ethereum's use cases, but the blockchain market as a whole is rising rapidly, meaning this is not a zero-sum game. Like in any market, some will rise to the top and dominate, some will have a mediocre presence, and some will cease to exist.
Still, a lot is at stake (no pun intended) for the success of this Merge. Any malfunction or hiccups resulting from the Merge, especially if users’ funds are compromised, will likely result in reputation hazard and devaluation of the Ethereum network. This devaluation may not be contained only to Ethereum and might rattle the entire crypto market, which is already experiencing a crypto winter.
But if successful, the Merge will further support and elevate Ethereum's dominance and value in the crypto and blockchain space.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.