The Ethereum merge is finally coming!

What happened

Last week, an Ethereum test blockchain, named Gorli, successfully changed its consensus mechanism from proof-of-work to proof-of-stake. This was the third and final rehearsal on a testnet, which is a network that mimics the Ethereum functionalities allowing developers to design, edit and test smart contracts and apps without the need for real money or crypto.

The success of these tests paves the way for the change of consensus mechanism on the main environment of Ethereum. This major update has been in the pipeline for years, and now a date has been set.

Impact on our Investment Case

What is the Merge?

The Merge is part of a series of upgrades that will ultimately make the Ethereum protocol more efficient, scalable, decentralized, sustainable, and secure.

In more detail, the Merge is the combination of the network used today for Ethereum transactions, secured by a proof-of-work consensus, with the Beacon Chain, a network launched in late 2020 that uses a proof-of-stake consensus. The coordination of the network of validators has been the main task of the Beacon Chain since it was launched. Once the two systems are joined together, transactions going forward will only be validated through the proof-of-stake consensus mechanism that has been used on the Beacon Chain. The two chains that have been running in parallel since the end of 2020 will literally "merge" (one chain bringing the transactions, the other one the consensus).

Why does it matter?

Changing the consensus to proof-of-stake is going to reduce (1) the number of Ether (ETH) issued and (2) its energy consumption. This is a major upgrade in Ethereum's tokenomics.

1. Miners (proof-of-work consensus) and validators (proof-of-stake consensus) are compensated for their work. This is an incentive to verify transactions and secure the network. The reward is given in the form of newly issued ETH. To reduce the inflationary pressure of the rewards, the “London update” of 2021 initiated a burning mechanism (removing tokens from circulation). Simply put, the number of coins eliminated depends on the level of activity on the network. The higher the activity, the higher the number of coins burnt.
   
   Mining consumes a lot of energy and requires state-of-the art hardware. For this reason, rewards have been relatively high to keep miners incentivized. In aggregate, Ethereum miners receive on a daily basis 13’000-14’000 ETH.
   
   Staking has less constraints. Almost anybody can run a validator node with a standard computer. Therefore, fewer incentives are needed to secure the network. The daily issuance of ETH on the Beacon chain is ~1’600 ETH.
   
   After the Merge, the coins paid until now to miners will not be issued anymore. Only the coins paid to validators will be issued. The daily issuance of ETH will fall by ~90%. If we consider the ETH that will be burnt, the net supply of ETH will grow in the worst case at ~0% per year and it is likely to be deflationary if the activity on the network surges again.  
   
   
2. The change of consensus will reduce the energy consumption of the Ethereum network by 99.95%. Securing the Ethereum network will require ~0.01 TWh (from 112 TWh with proof-of-work). This is roughly the energy consumption of 1’000 U.S. households. As a comparison, the Swedish KTH Royal Institute of Technology estimated the energy consumption of Youtube in 2019 at 243 TWh (or >1% of the global electricity consumption).

When will the Merge happen?

The Merge will be deployed in two phases. A first upgrade will kick off the process on 6 September 2022. The actual merge will then happen on 15-16 September 2022. This date will mark the last block mined by proof-of-work; the next one will be produced by proof-of-stake. Everything will happen in the background. The users of the protocol or the holders of the crypto do not need to do anything.

Can the Merge go wrong?

The testing of the transition to proof-of-stake has been important, but the probability of an unsuccessful merge is not null. Simply put, the Merge is a software update. History has proved that even the most famous software solutions were not immune from unexpected problems when updating.

Will the transaction fees on Ethereum go down?

Transaction fees reflect the use of the network. The higher the demand for transactions on the protocol, the higher the transaction fees. They were high during the Decentralized Finance (DeFi) or the NFT hype, and they have currently been low as we are going through a crypto winter.

The Merge will have no impact on the block space or the network capacity. As a consequence, the Merge is not expected to significantly reduce the transaction fees. The shard (another update, see below) is a different story and will likely reduce transaction fees.

Will there be any impact on the staking yield?

The staking yield is a return offered to validators. They receive compensation in exchange for securing the network. The compensation (or "reward") is based on the number of validators: the higher the number of validators and staked Ethereum, the lower the expected return. 

With the switch to proof-of-stake, validators will also receive transaction fees. These fees were previously distributed to the miners. Given the current number of staked ETH, the annual percentage rate of return is at ~4.1%. If we include the transaction fees, the return would increase by roughly 50% to ~6%, assuming the activity on the network remains at the current low levels. 

Is the Merge the final step for the “most significant upgrade” of Ethereum?

The Merge is part of a series of upgrades that are still far from being completed. The upgrade project should be over in 2024, if there are no development delays. Two important pending developments deserve to be highlighted.

First, staked ETH (coins put at work to secure and ensure the functioning of the protocol, and earning their owners the staking yield) are currently illiquid and locked. This has been the case since the launch of the Beacon Chain. The "Shanghai" update (planned to be deployed 6-12 months after the Merge) will allow validators to withdraw their staked ETH. Moreover, the Shanghai update will set rules about the number of coins that can be unstaked in a given day, to ensure that the ~14mn ETH staked (~12% of the total supply) are not unstaked at the same moment which would cause a huge selling pressure and a panic exit. Developers have limited to ~43’200 ETH unstaked per day. In other words, it would take almost one year if all validators wanted to exit the protocol at once.

A mass exodus is however unlikely, because the staking reward is dynamic (the lower the number of ETH staked, the higher the income per validator). 

Second, the next big step will be to improve the scalability of the network through solutions like sharding (split of the network into multiple portions). This update was initially scheduled before the Merge but was then postponed due to the surge of layer 2 protocols which improve significantly scalability issues (since transactions are not directly recorded on the main protocol). At this stage, Ethereum will be able to process ~100’000 transactions per second (currently ~15), outpacing networks like Visa (whose servers would in theory be able to process 60’000 transactions per second). This will be a major development for the tokenomics of Ethereum as scalability will not be a concern anymore.

What will be the impact on the price of Ethereum?

The Merge is a major event, not only for Ethereum but for the entire blockchain ecosystem. Institutional investors will find an asset that is ESG compliant and that offers attractive yields. Having said that, volatility will remain important. We cannot exclude that some opportunistic investors sell on the news, once the merger is completed.

In the longer run, Ethereum will benefit from the significant improvement in tokenomics caused by the updates. They do not only boot the supply side (less token issued, higher yields, environmental friendly, etc.), but also the demand side. We can expect more users and applications on the network. Improved scalability and lower transaction will eventually encourage more developers to launch applications on Ethereum, which will bring new users to the platform. Ethereum is likely going to consolidate its position as the market leader in decentralized protocols for smart contracts.

Is there any regulatory risk?

Up to now, Ethereum has been considered by the SEC as a commodity – like Bitcoin. This could change with the switch to proof-of-stake.

The SEC uses the Howey test to determine if an asset is a security, which says “an investment contract exists if there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others”. Staking is a clear investment of money. The common enterprise is also almost always satisfied when looking at digital asset projects. However, the expectation of profits and efforts of others is more tricky and would depend on how decentralized the network really is.

Given its market cap, it is likely that the SEC will look at this case. If qualified as a security, the biggest consequences would impact exchanges. Exchanges would have to delist Ethereum or register as securities exchanges. It would become more complex for people to buy or sell Ethereum. A never-ending legal case, like for Ripple (an SEC lawsuit started two years ago to determine if Ripple was a security), would also probably start. In the meantime, the fast-changing regulatory framework could be adapted and provide clarity to avoid any hassle, and both U.S. and European legislators are already working on it.

What will happen to miners?

Ethereum has been a multi-billion dollar source of revenue for miners ($19bn in 2021, $8bn year-to-date). With the change of consensus, miners will lose all income – and they are obviously not happy about it!

Groups of interest (i.e., upset miners and a few large Ethereum holders) raised their voices, arguing for another hard fork to continue a proof-of-work consensus. Officially, this protocol would be a backup plan in case the Merge failed. In reality, they just try to protect their business activity. Even if a new proof-of-work chain was created ahead of the Merge, it is doomed to fail due to a lack of support. The transition to proof-of-stake is widely accepted and desired by the rest of the Ethereum community.

Instead of creating a new protocol, most Ethereum miners are simply expected to switch to other proof-of-work protocols where their hardware can be used to mine. The best candidate is Ethereum Classic (ETC). Back in 2016, following a hack, the Ethereum network split in two. The unaltered transaction history (including the hack) continued as Ethereum Classic (ETC), while a new chain that did not show the hack was created as Ethereum (ETH).

Within the listed miners, Hive Blockchain announced that it was studying Ethereum Classic, while Northern Data took a different approach: it will stop mining and will convert its GPUs (graphic cards) to cloud services. This latter approach is likely to be followed by the largest miners. Excluding Ethereum, the total market cap of coins (e.g., Ethereum Classic, Ravencoin or Ergo) that can be efficiently mined with GPUs is very limited (<5% of Ethereum market cap). These GPUs would not be useful to mine Bitcoin (mostly mined through customized chips for a particular use case, ASICs).

Is there any impact on the semiconductor industry?

The demand for GPUs is likely to be further hit by the Merge. In its recent profit warning, Nvidia explained that the weaknesses of its gaming division are due to the macroeconomic environment. Many gamers upgraded their PCs during the pandemic and are now taking a break in the replacement cycle, given ongoing uncertainties.

However, Nvidia also found itself in a comfortable situation where a supply-demand imbalance, increased by miners, allowed the firm to sell its GPUs at almost any price. Miners have stopped or reduced their purchase of GPUs due to the crypto winter and also probably in anticipation of the Merge. The company will need to adapt to this new reality.

Finally, we can note that GPU mining has been quite popular with retail miners, and the Merge will affect them as well. The number of second-hand GPUs on sale on classified advertisements websites is surging, with prices down ~20% in just a few weeks.

Our Takeaway

The Ethereum protocol is about to experience a significant change in its tokenomics: (1) reduction of newly issued coins by ~90%, (2) increase of staking reward by ~50%, and (3) reduction of energy consumption by ~99.95%.

The change of protocol for Ethereum is a major development that will have an impact on the entire ecosystem. It will be interesting to see if U.S. regulators consider that these changes make Ethereum a security rather than a commodity. But besides that, the entire community but miners is looking forward to the proof-of-stake transition. The improvement of the protocol will encourage developers to launch new applications, which will bring new users to it. In the end, Ethereum is going to consolidate its leading position as a smart contract platform.

The Merge and the upcoming updates should support ETH, and even create a surge in interest for digital assets that could end the crypto winter sooner than expected. Our strategy Blockchain & Digital Asset is ideally positioned to benefit from this significative development in the Ethereum blockchain and all its ripple effects. 

Sources: Ethereum Foundation, Messari, KTH Royal Institute of Technology, The Block