What Does This Mean for the Broader Digital Asset Industry?
In the upcoming months, Ethereum will likely undergo the most significant technical upgrade in its history, referred to as “The Merge”. The move from Proof of Work to Proof of Stake consensus is a transition that will improve Ethereum’s security, drastically reduce its energy consumption, and have implications for the entire ecosystem.
In this quarter's commentary, we will discuss:
What is Proof of Work and Proof of Stake?
Digital assets are a result of one of the technology industry’s newest and most exciting innovations, blockchain technology. Both Proof of Work (PoW) and Proof of Stake (PoS) are consensus mechanisms. A consensus mechanism is simply a system blockchains use to validate the authenticity of transactions on a network. Each type of consensus has common goals of providing transparency to transactions, making it difficult to commit fraud (such as a double spend), and maintaining security (by distributing power and not giving too much authority to any one player). PoW is the consensus mechanism that Bitcoin uses, and verifying transactions is done via mining, which uses high powered hardware to solve complex algorithms. PoS consensus involves locking up the chain’s tokens, and validators are chosen based on a set of rules and the amount of tokens (economic value) they have staked. Both mechanisms have tradeoffs, which we will touch upon later on. One of the key differences is energy usage, of which PoS is much more efficient.
Brief Summary of The Merge
The simple explanation of “The Merge” is a point in time where the current Ethereum Mainnet merges with the new PoS Beacon Chain to become one (see below graphic). This is the point at which Ethereum no longer runs a PoW consensus mechanism and will officially run on PoS validation. The Merge marks an important milestone in Ethereum’s development, as it is estimated that Ethereum’s roadmap will be ~55% complete after this upgrade1. With the Merge behind them, Ethereum developers and community members will be able to focus their time and energy on the subsequent efforts on the roadmap, such as sharding and rollups. These upgrades to the network are estimated to increase network output from approximately 15 transactions per second currently to over 100,000 transactions per second. This improvement in Ethereum’s throughput combined with its security would potentially make it competitive with other global transaction platforms.
The Merge has been under development for a few years, and there is already a live staking contract that was launched in October of 2020, shortly preceding the launch of the Beacon Chain. Users may deposit ETH into this contract to directly participate in consensus and to become a validator to secure the network.
Instead of miners using high-powered machines that use lots of electricity to validate the network, Ethereum will soon utilize the PoS consensus, which uses much less energy. In the current PoW system, validators/miners are awarded newly minted tokens from the network for ensuring the authenticity of transactions – we will refer to this as new issuance. In the post-Merge world, issuance will be paid to ETH stakers rather than to miners for securing the network. This dynamic shift should have drastic impacts on the price of ETH around and after the Merge. Not only does this give more users a chance to participate in network security, but it also possibly increases decentralization, as more are able to participate in validation given that upfront costs are substantially lower. Furthermore, new issuance currently goes to validators who are natural sellers (miners) given the need to pay high overhead and hardware costs. Post-Merge, new issuance will go to stakers who are not necessarily natural sellers, as they likely believe in the long-term value of ETH. This has the chance to radically alter the investment flows in a way that may prove favorable to ETH holders.
Possible Price Impacts from the Merge
We believe that the Merge will have a positive impact on the price of ETH because:
- The reduction in issuance and the fee burn creates favorable supply side dynamics for ETH token holders
Given that PoS is less resource intensive than PoW, it is cheaper to provide security to the network. Since it is cheaper, it requires less inflation of ETH (new issuance), meaning less new supply each year than is currently issued under PoW. Additionally, with the implementation of EIP-15592, a large majority of ETH gas fees have been and will continue to be burned, further reducing available supply. Miners (net sellers) will be out of the picture after the Merge, and new issuance will go to stakers who may naturally be more bullish on the asset and hold more of new issuance for the long-term. The combination of a large reduction in new issuance and EIP-1559, resulting in a majority of ETH fees being burned, is estimated to lead to a net reduction in supply of ETH of between 70-90% per year post-Merge3. This reduction in supply is likely favorable to price, all other factors being equal.
- Demand for ETH is likely to increase to capture staking yield and to speculate in DeFi/NFT’s (in the medium to long-term)
As the Merge approaches, sophisticated market participants will be anticipating this important upgrade. Many have already begun staking ETH in anticipation of the Merge and the subsequent increase in staking yield that will result. We believe that as macro-economic headwinds abate and with the deleveraging cycle in digital assets behind us, both individuals and institutions will return to both DeFi as well as NFTs and this will drive overall demand for ETH. 2021 featured unprecedented growth in usage of crypto applications such as Decentralized Finance (DeFi) and Non-Fungible Tokens (NFT’s) and these applications increase demand for ETH as it is used as a medium of exchange for NFT’s, a base pair for liquidity provision on decentralized exchanges, and of course, to pay transaction fees on the Ethereum network. This combination of factors leads us to believe that there will be a much higher demand for ETH in the medium term than there currently is.
In our view, a favorable dynamic is playing out with the Merge; one which drastically reduces the new supply via reduction in issuance and fee burn with a return to normalized or increased demand for ETH in the future. As we get closer to and through the Merge, we believe this is a recipe for significant upside in the token price.
Merge Risks and Mitigants
The conversion of a consensus mechanism is a project of significant technical complexity. While we will not attempt to categorize all the risks, we view two of the most significant risks as follows:
- The risk that the Merge is not achievable from a technological perspective
- A technical glitch/bug which impairs blockchain functionality or causes a significant loss of funds
The risk of (1) is mitigated by the results from the recent testnet4 Merge events. There is a high level of confidence based on approximately two years of testing at this point that the transition to Proof of Stake is highly achievable. The fact that the Merge on the Ethereum testnets were successful gives reassurance that the Mainnet Merge can be successful.
For (2), there are two mitigants based on our research worth noting:
The Human Element: Tim Beiko
Tim Beiko is a developer for the Ethereum Foundation and currently leads the Core Developer meetings for the Merge. Flowtrack participates in the Core Developer calls and Discord chat forums, and we also pay close attention to Tim’s Twitter updates and blog posts. It is evident to us that his rare combination of talents is a huge asset to the Ethereum Foundation. While we are not downplaying the visionary leadership of Vitalik (co-founder of Ethereum), Tim is central to the execution of this project. He is a strong leader who canvasses the opinions of the different groups and parties involved, weighs the risks effectively, and is decisive about either forward movement or a pause depending on the information he has assimilated and analyzed. His balance of management skills in combination with his technical knowledge instills confidence in us as investors. In the end, whether you are evaluating an investment in a large corporation or a decentralized network, it is wise to consider the leadership’s ability to execute, and his leadership qualities are on par with any we have seen in the private, centralized world.
Ethereum’s Advantage: Client Diversity
Nodes in a network/blockchain play a vital role in its operation and function; they keep the system running and enforce the rules of the network. Nodes need software programs to do their busy work, and those programs are called “clients.”
It would be far simpler to have one client that everyone uses to run their programs. However, Ethereum from very early in its development made the decision that running multiple clients was the correct strategy for improving the security and resilience of the network. This concept is known as Client Diversity.
Ethereum has multiple interoperable clients developed and maintained in different languages by independent teams. This is a major achievement and can provide resilience to the network by limiting the effects of a bug or attack to only the portion of the network running the affected client.
Client Diversity provides resiliency against:
- Technical bugs in code
- Hacking attacks
- Inability to arrive at consensus (finalizing blocks)
The current goal of the Ethereum Foundation as well as the target that is most healthy for the network is no client having greater than a 33% share. There is a significant effort by the Ethereum team to improve the current concentration of the network (www.clientdiversity.org).
Since January, there has been a drastic improvement in the consensus clients diversity with Prysm moving from ~66% share to ~36% and Lighthouse moving from ~19% to ~33%, further proving that the efforts of the team are bearing fruit.
Despite the potential for improvement, the strategy has already proven to be an important defense against past malicious attacks:
“the Shanghai denial-of-service attack in 2016 was possible because attackers were able to trick the dominant client(Geth) into executing a slow disk i/o operation tens of thousands of times per block. Because alternative clients were also online which did not share the vulnerability, Ethereum was able to resist the attack and continue to operate while the vulnerability in Geth was fixed.”5
The redundancy in different clients alone provides security against a number of the most significant threats to the network. Given the importance of this strategy for the overall health of Ethereum, we will continue to monitor and track these metrics post-Merge.
All participants should be aware of the potential risks associated with the Merge, no matter how low the perceived probability of each. It is important to be cognizant of the fact that the Merge will likely cause radical changes in many parts of the industry, and with that, possibly resistance of some sort by certain parties. If the Ethereum community can mitigate these risks and facilitate a successful Merge, it should be a net positive for the community and industry as a whole.
Implications of the Merge for the Industry as a Whole
The Merge is one of the most important events in the industry’s history and could have a profound impact on the digital asset landscape for years to come. Not only does it have implications for Ethereum’s energy consumption and the supply and demand dynamics of ETH, but it could also make Ethereum more secure. As there are reduced hardware requirements for Proof of Stake, there is a lower barrier to entry to run a node and secure the network, likely improving decentralization. With the largest smart contract chain by activity and users moving to PoS and vastly reducing energy consumption, it will hopefully alleviate some of the regulatory scrutiny around the industry. Furthermore, with the Merge behind them, the Ethereum community can begin to focus on the next steps of the roadmap such as sharding and rollups, which is estimated to dramatically increase scalability and reduce transaction costs, paving the way for the development of the applications of the future.
(4) An instance of a blockchain powered by the same or a newer version of the underlying software, to be used for testing and experimentation without risk to real funds or the main chain