How Ethereum is changing in 2022 & what the impact will be

Towards the end of 2022, Ethereum is expected to undergo the biggest transition in its seven-year history. Described as The Merge, Ethereum’s consensus method will change from Proof of Work to Proof of Stake. Not only will this make Ethereum more environmentally friendly, but the issuance of ETH will also be dramatically cut and the foundations laid for huge improvements in scalability. 

Ever since Ethereum was launched in July 2015, it has used the same consensus method as Bitcoin, called Proof of Work. That is all going to change when the Merge sees a separate chain - the Beacon Chain - which has been operating Proof of Stake since December 2000 - merge with the main Ethereum blockchain. From that point on Proof of Stake will be how Ethereum reaches consensus.

This is the analogy that Ethereum official site uses to explain the momentous upgrade in layman’s terms:

"With the Beacon Chain, the community has built a new engine and a hardened hull. After significant testing, it's almost time to hot-swap the new engine for the old mid-flight. This will merge the new, more efficient engine into the existing ship, ready to put in some serious lightyears and take on the universe."

To understand the significance of Ethereum’s switch to Proof of Stake as a ‘new engine’ you first need to understand a little bit about blockchain Consensus Methods.

What is a consensus method?

A consensus method is how a blockchain -- a distributed network of independent computers -- achieves agreement on the accuracy of new data in a shared ledger.

In the case of Bitcoin, which is a new type of monetary system, the shared ledger is updated to reflect unspent recent transactions and the amounts of bitcoin held in UTXOs (unspent transactions) the equivalent of account balances. 

Ethereum operates as a computational engine - described as the world computer - and a monetary system denominated in Ether (ETH). So consensus must be reached on the state of computations (executed through Smart Contracts) for supporting digital applications (dApps) and balances of accounts holding Ethereum. Both are recorded in something called the Ethereum Virtual Machine (EVM)

Proof of Work takes its name from network participants, known as Miners, having to prove that they have committed sufficient work to add new blocks of data to the shared ledger described as a blockchain. 

The required work is to continuously run a specific software algorithm, consuming electricity in the process, in order to solve a maths puzzle. The winner receives a reward in bitcoin or ether and the right to publish a new block. 

Proof of Work’s electricity consumption produces what economists call a negative externality; Bitcoin and Ethereum gain security but the world has to deal with the C02 emissions.

Proof of Work is the only way the supply of bitcoin and ether grows, so given one of the fundamental properties that gives money value is scarcity, consensus methods dictate the coin supply schedule (the rate that new coins are added) which matters to price.

In addition to the block reward, Miners receive fees for transactions added to new blocks. Competition for limited block space drives up fees so the Consensus Method plays a key role in incentivising Miner participation and determining the cost of a transaction.

Proof of Work incentivises good behaviour as it makes no sense to consume costly energy and attempt to add false transactions to new blocks which the rest of the network will reject.

Bad actors can only succeed by controlling more than 51% of the overall Mining power, known as Hashrate, to be able to successfully add new blocks with false data. So it's important that the barrier to entry for Miners is low, to discourage collusion.

That barrier to entry includes the ease of downloading and storing the entire blockchain and running the software that includes the consensus rules. So the Consensus Method is fundamental to the security of the overall system.

The Consensus Method adds new blocks of transactions of fixed size and at a fixed rate - for Ethereum this presents a limit of about 15 transactions per second. This determines how scalable the system is, because if the rate and size are fixed and demand for transactions increases, then the cost of transactions is only going to increase.

So Ethereum changing its consensus mechanism is a big deal because:

• it will have an impact on scarcity which influences price.
• It changes the incentive structure for validating transactions.
• It might influence the cost of processing a transaction.
• It is fundamental to the security of the overall system.
• It impacts how scalable the system is.
• It will change its environmental impact

We can now look at the impact that Ethereum’s plan to move to Proof of Stake going to have specific to each point.

The Merge - Issuance & Scarcity

One of the biggest criticisms of Ethereum in its current form is that, unlike Bitcoin, it has no supply cap. At the time of writing Ethereum’s annual emission rate - the level at which new ETH are created via block rewards - is just under 4%. 

However, the actual rate of inflation is close to 0.5% because of the impact of EIP 1559, a change to the function of Ethereum that came into effect in August 2021 which sees a proportion of transaction fees burns. After the Merge with fees burned, lowered rewards and so many ETH locked Ethereum’s inflation rate is expected to be neutral, i.e., 0%. 

This plays into one of the biggest arguments for crypto vs fiat money -- that it is a hedge against inflation because its supply is fixed and programmed. Ethereum supporters see it as transitioning to ultra-sound money.

This will bring a huge benefit to those already holding Ethereum, knowing the value of their funds isn’t being eroded. It will also act as an incentive for more users to stake funds, as the net benefit of the rewards will be greater.

The Merge - The change to incentives

The move to Proof of Stake completely changes Ethereum’s incentive structure for the essential work a Validator provides - storing data, processing transactions, and adding new blocks. Rather than earning rewards in proportion to energy contributed they will be distributed probabilistically based on the portion of overall ETH staked. 

You need at least 32 ETH to be a stand-alone Validator, which is outside the means of most people but you can instead join a staking pool. By joining a staking pool, you delegate your ETH to a validator and earn proportionate rewards for securing the network by proxy. 

Ethereum staking has been live since December 2020, with close to 13 million ETH locked at the time of writing worth over $13b. Staking has been generating a passive return of around 4%, but despite some claims that this will increase to anywhere from 10-15% after the Merge completes, the official Ethereum site estimates APY to increase by a more modest 50%.

Staked funds cannot currently be withdrawn, which will remain the case for a period after the Merge, protecting the value of Ethereum by preventing Stakers from immediately selling rewards. This means that at current staking levels around 11% of Ethereum’s supply will be locked until the Shanghai upgrade, expected 6-12 months after Merge.

The change to the way blocks of transactions are validated after the Merge is also expected to also discourage some of the dark arts of block reorganisation where under PoW miners try to extract value by prioritising or ‘front running’ transactions in a process known as MEV (Miner Extracted Value). 

The Merge - Scalability

One of the most fundamental problems that The Merge is intended to solve is Ethereum’s scalability. Under PoW the only way more transactions can be processed is by increasing the size of a Node, which would centralise the network with powerful and expensive computers, or by increasing the speed of block production - which would change the supply schedule and impact security. The solution is something called Sharding.

Sharding will attempt to spread out the demands of the network, splitting one chain into potentially 64 new chains. Having far more chains might seem counterintuitive if this aim is to reduce the demand on Nodes, but Validators - who maintain the network - will only have to run one shard, not the whole network.

The outcome should be lighter-weight Validators, making it easier to be a Validator and making Ethereum more decentralised. However, before you get too excited Sharding isn’t expected until 2023 and the official Ethereum website states that it is a misconception that transactions will be faster or cheaper. 

Improvements to scaling will take time and may come more from the innovation of layer 2 applications and if/when Sharding is live.

The Merge -- Proof of Stake & Environmental Impact

Ethereum estimates that its energy use will drop by 99.95% as a result of the move to Proof of Stake. This is because the network will be secured by the Ethereum staked by validators, rather than an ongoing requirement to consume electricity.

Though there is no conclusive data, Ethereum refers to analysis from a site called Digiconomist which compares current PoW energy consumption to that of the Netherlands. 

Digiconomist’s methodology and reasoning have been challenged by the Bitcoin community. but it cannot be denied that post-Merge Ethereum will undoubtedly be 100x less energy-intensive. Whether that trade-off improves its security is an open question.  

Consuming electricity is a value judgement. A lot of people consume electricity to power Christmas Lights, Bitcoin consumes electricity to support a censorship-resistant form of money because its supporters feel Proof of Work is the only consensus mechanism that generates genuine decentralisation. 

Ethereum’s switch to Proof of Stake means that security derives from users making a financial pledge. Some argue this leaves Ethereum more vulnerable to collusion, especially as most staking is via delegation to staking pools that can easily be gamed.

The Merge -- Challenging Bitcoin

One of the biggest potential outcomes of Ethereum’s Merge is presenting a greater challenge to Bitcoin’s dominance as the most important cryptocurrency.

Any and all of the positive impacts that Proof of Stake might bring could combine to make Ethereum more investable, but that assumes:

• that there is no improvement to Bitcoin in the meantime
• that Ethereum’s position isn’t challenged by other Layer 1 chains
• that the Merge actually achieves its aims

The argument between Ethereum and Bitcoin Maximalists will never be settled, but for those that are outside of the battles that rage on Discord and Twitter, it is likely that they will simply focus on the most obvious change; the dramatic reduction in Ethereum’s energy consumption. 

This will also play out well with regulators and politicians who don’t understand or even care to understand, the deeper nuances of the issue of Proof of Work’s environmental impact. 

Combine the environmentally friendly message, with improved staking rewards and the ultra-sound money tag, and Ethereum has some clear USPs that the average Joe can understand, without having to get knee-deep in technicalities. 

Merge Timeline

The Beacon Chain was created on December 1st, 2020 existing as an isolated Proof of Stake chain, and has amassed over 400,000 validators and almost 13 million staked ETH.

So the question on the lips of those Ethereum supporters that have staked funds is ‘when will the Merge happen?’ 

Unfortunately, the Ethereum Foundation cannot give a hard date as launches of complex technology aren’t an exact science but some of the crucial milestones have already been met.

Ropsten, Ethereum’s oldest proof-of-work testnet, transitioned to proof-of-stake on June 9th, while two shadow forks took place in May. Shadow Forks are test runs of the Proof of Stake chain in simulated real-world conditions.

The next big Merge milestone to look out for is the Gray Glacier scheduled for block 15,050,000 around June 29th. This will push back Ethereum’s difficulty bomb by 100 days, the mechanism used to increase mining difficulty and essentially freeze the chain. It has been widely seen as the precursor to the Merge, so it looks like Ethereum devs have the summer to run more tests and simulations with the ‘on’ switch being flicked around Q3/Q4 2022 according to the Ethereum blog. 

Of course, the Merge itself isn’t the end of the road. Stakers won’t be able to withdraw ETH earned prior to and after the Merge until the Shanghai upgrade which isn’t expected for six-to-twelve months.

Though the Merge itself is a huge focus for the Ethereum community change will be a continuum with sharding not expected to be integrated until 2023.

What could go wrong with Ethereum’s Merge?

Ethereum’s switch to Proof of Stake has already had a number of false dawns with initial expectations suggesting it might happen back in 2019. So if we put on a pessimist’s hat, what could go wrong with the Merge?

It doesn’t happen

If we think about what could go wrong with the Merge, the first consideration is that it might get pushed back again. History has shown that milestones in the Merge process have been hard to keep but the recent shadow forks suggest that most of the problems have been ironed out with the finishing line almost in sight. Nevertheless, there is a non-zero chance that it just won’t happen.

It gets overshadowed by the Bear Market

As much as the Merge is expected to improve Ethereum’s fundamentals price is still driven by perception. This is why with just months to go until Ethereum changes to Proof of Stake, with all the potential benefits, the price is down by 75% from its All-Time High.

The Bear Market and the hangover from Terra’s collapse could, therefore, suck a lot of the energy out of the Merge and limit investment in new projects and the development of new applications. Borrowing terminology from the Gartner Hype Cycle (a technology adoption model) as a guide, Ethereum could find itself stuck in the trough of disillusionment before positivity returns to the broader market.

It doesn’t have a meaningful impact on fees/speed

There is a huge amount of expectation around the Merge, so the danger is that it simply doesn’t live up to the hype. Ethereum’s own website is explicit in managing expectations, pointing out that fees aren’t expected to fall and speed isn’t expected to increase.

The decision of the popular crypto derivatives platform, Dydx to switch to Cosmos for its next update,  just months before the biggest improvement in its design was interpreted as a recognition that confidence in Ethereum’s direction isn’t universal.

In giving its reasons Dydx stated that neither Ethereum L1 or L2 applications couldn’t provide the necessary speed, transaction throughput or required level of decentralisation.

Sharding doesn’t enable scaling

Sharding isn’t built into the Merge, it comes later but much of the improved scalability is pinned on it. There is a chance that the technology behind sharding simply doesn’t work.

An important final note regarding Ethereum’s long-anticipated switch to Proof of Stake is how the huge wave of negativity that has swept over the entire crypto sector may put even more pressure on the Merge.

If Ethereum devs can pull the Merge off it could provide a much-needed point of optimism that would benefit the whole industry. At the same time, the switch to a more environmentally friendly consensus mechanism might win more favour for crypto from casual observers.

No pressure, Vitalik.