The Merge of Ethereum

Introduction

Ethereum is a blockchain-based technology that manages and stores data in a manner similar to the better-known Bitcoin, but which has its own native coin^1/ called Ether, or ETH, a type of cryptocurrency that may be used to pay for services and transaction fees. Ethereum also differs from Bitcoin by providing users with additional programming capabilities that may be coded to execute automatically once certain conditions are met. The possibilities offered by these ‘smart contracts’ are one factor underpinning interest in Ethereum and driving efforts to extend its capabilities and improve the efficiency of its operations. Most recently, this has led to ‘the Merge’, an event that has marked a major change in how the Ethereum blockchain operates.

Blockchain Trilemma

Within the realm of digital assets, blockchain technology should be developed to optimize all 3 of these characteristics simultaneously within a blockchain network, which include:

1. Decentralization: The ability to operate in the absence of middlemen and other types of intermediations, i.e., eliminating the need for a central authority.
2. Security: The ability of the system to deter threats and maintain cybersecurity. A secure blockchain ensures the integrity of transactions and the confidentiality of sensitive information.
3. Scalability: The ability of a blockchain network to handle a growing number of transactions and users without compromising its performance.

However, investors and blockchain gurus alike agree that at least up to the present day, it has been impossible to fully satisfy all three requirements simultaneously, the challenge  that has been named the ‘blockchain trilemma’.
 

Given the current shape of the digital asset landscape, most blockchain networks meet at most only two of these three requirements. Improving one aspect often comes at the cost of another. Although Ethereum was both secure and decentralized3/ , it had previously failed to meet the requirement for scalability. However, this weakness has been addressed by the Merge of Ethereum, which has formed part of the move to upgrade the network’s capabilities and to ensure that the blockchain trilemma is resolved by achieving the perfect balance between scalability, security, and decentralization.

What is The Merge of Ethereum

Prior to the Merge, to verify transactions and to record data, account balances, and smart contracts coded and operating on it, the Ethereum Mainnet (i.e., the live Ethereum blockchain deployed for daily use) was based on a Proof of Work (PoW) consensus algorithm. However, the use of a PoW mechanism carries with it significant problems with regard to scalability, and so to overcome these difficulties, a decision was made to switch to a Proof of Stake (PoS) algorithm instead. The transition from a PoW to a PoS consensus algorithm occurred in two major phases: (i) the  creation of a separate yet parallel network alongside the Mainnet called ‘the Beacon Chain’ that uses the PoS mechanism; and (ii) the process of merging the Beacon Chain with the existing Mainnet, also known as 'The Merge'.

The Beacon Chain was developed as a separate layer of the Ethereum blockchain. In the initial phase of the switch to the PoS consensus algorithm, the Beacon Chain operated in parallel with the Mainnet, allowing developers to test the system and to deal with problems as and when they arose, without this impacting the functionality of the existing Ethereum network itself. Once it was clear that the Beacon Chain was operating as designed and that use of the PoS mechanism would not generate problems for users on the Ethereum blockchain, it was then possible to integrate the two layers.

The Ethereum Mainnet and the Beacon Chain have been successfully integrated—this is The Merge of Ethereum—and so the Ethereum blockchain now fully operates on a PoS rather than a PoW consensus mechanism.

Following the success of the Merge, the Ethereum network is now looking at implementing a new method of storing data called sharding, which may be used on blockchains. Under this system, the network is split into separate smaller self-managing units called shards, which in the Ethereum network can be connected using the Beacon Chain, with the goal that 64 shard chains will operate simultaneously. The result of this will be to allow the Ethereum network as a whole to process up to 100,000 transactions per second (TPS), significantly cutting processing time and costs and dramatically extending the network’s scalability.

Vitalik Buterin, the Russian programmer behind ETH and the Ethereum blockchain, spoke about how Ethereum might solve the blockchain trilemma at Ethereum 2022 (EthCC), an annual conference devoted to its namesake technology that in 2022 was held in Paris between 19 and 22 July . At the conference, Buterin outlined the details of how upgrades to the Ethereum network would enable it to meet all three of the main requirements for a comprehensive blockchain solution. At that point, the Merge was more than 90% complete, with just some work on Testnet remaining to be completed^5/. It was later announced that as of 20:42  Thailand time on 15 September 2022, the Merge of Ethereum had been successfully completed.

Bringing The Merge to completion

In the recent past, one criticism leveled at cryptocurrencies has been their voracious energy consumption, a situation that many believed was only likely to worsen in the future. In particular, the demands placed on power supplies by the cryptocurrency industry escalated sharply over 2018-2022, and estimates place the industry’s total global power consumption at 120-240 TWh annually. This is a significant amount of electricity, and in addition to being in excess of the total national demand of major economies such as Argentina and Australia, cryptocurrencies are estimated to account for 0.4-0.9% of global energy demand.^10/ Alongside other blockchains, Ethereum was guilty of profligate energy consumption, and prior to the Merge, the Ethereum blockchain is estimated to have used 46.31-93.98 TWh of electricity annually,^11/ an astounding amount that resulted in a carbon footprint^12/ of 11,016,000 tonnes of carbon dioxide equivalent (CO2e).^13/ 

Problems with some blockchains’ excessive energy consumption originate in the use of the PoW consensus algorithm. This contributes somewhere close to 100 TWh annually to global energy demand, a figure that is itself comparable to the entire annual electricity consumption of Colombia or the Czech Republic, and so this was a major driver of the desire to transition the Ethereum network to the PoS mechanism. The total electricity demands generated by using PoS systems to verify transactions come to just 0.0026 TWh per year, or something like 0.01% of the PoW total (i.e., this represents a 99.99% energy saving). In terms of estimated overall consumption, the Merge should thus result in the Ethereum blockchain going from using as much electricity as a mid-sized economy to using as much as a small US town containing around 2,100 households.^14/ The collapse in energy usage associated with the PoS systems stems from the fact that rather than being selected through a race to the first correct answer, the system employs a semi-random selection process to find Validator,^15/ who adheres to the blockchain regulations to verify transactions. As a result, there is only one validator per block.

Market reactions to The Merge of Ethereum

The Merge was one of the most significant events to occur in the crypto space in 2022, following its successful completion, prices for ETH failed to rise, despite predictions from many investors that this would be the case. Rather, prices immediately dipped and then stabilized. This short-term decline was partly driven by rumors and misunderstandings surrounding the upgrade, with many believing that the Merge would result in the formation of a new blockchain, ‘Ethereum 2.0’, and a newly minted coin to go along with this, ‘ETH2’, though as has been shown above, neither of these claims were true. In addition, the Merge coincided with the latest ‘crypto winter’ and significant turbulence in the crypto world. Among the most important causes of the latter was the collapse of the FTX^19/ cryptocurrency trading platform, which prior to its being declared bankrupt was after Binance the world’s second largest crypto exchange. The value of ETH was thus impacted by the FTX scandal, losing over 30% of its value overnight; on 8 November 2022, ETH traded at USD 1,574.80 but only a day later, its value had slumped to USD 1,083.29.^20/ The market for ETH then remained choppy through 2022, closing out the year at around USD 1,300.

In addition to troubles originating from these market-driven price swings, the regulatory authorities have also begun to take a closer interest in ETH and its exact legal status. Gary Gensler, Chair of the US Securities and Exchange Commission (SEC) stated that following the merge and the 2022 transition from the PoW to the PoS consensus mechanism and the introduction of staking, it was possible that ETH could henceforth best be regarded as a security, and in that case, it would come under the purview of the US SEC. In assessing the case for this, the SEC applied the ‘Howey Test’. For ETH, this required considering whether holders of the coin expected to earn profits from a common enterprise, or in other words, the test assessed whether holding ETH was a type of profit-seeking investment. The result of the SEC’s assessment was that holders of ETH did indeed buy ETH exactly because they expected to earn a profit from doing so, and as such, ETH could be regarded as a type of security.^21/ However, at around the same time, on 13 December, 2022,^22/ the United States Commodity Futures Trading Commission (US CFTC) issued its indictment of Sam Bankman-Fried, the ex-CEO of FTX, and in this, the CFTC clearly regarded ETH as a commodity, much like Bitcoin and other cryptocurrencies. This conflict over the status of ETH and whether it should be classified as a security or a commodity then generated considerable uncertainty in the investor community since if it is the former, ETH will be regulated by the SEC, whereas if it is the latter, it will be regulated by the CFTC. Following the disagreement between the regulatory authorities, the waters were perhaps muddied further by comments made in May 2023 by Dan Berkovitz, ex-general counsel for the Securities and Exchange Commission, on the Unchained podcast, where Berkovitz stated that it is possible that from a legal perspective, ETH could fall within the scope of both the SEC and the CFTC.^23/

Following this period of volatility, demand for ETH benefited from a number of factors, including the decision by Google to offer blockchain node hosting,^24/ for which Ethereum was the first blockchain to be chosen. Vitalik Buterin also announced that following the Merge, the next upgrade to be made to the Ethereum network would be the Scourge,^25/ which would help to address problems with validators claiming additional fees for adding transactions to the blockchain. The Shanghai upgrade,26/ which was implemented at the start of April 2023, also allows validators to withdraw ETH that has been staked on the blockchain. These have then helped to improve perceptions of the Ethereum network and as such, prices for ETH have rallied; in the wake of the successful Shanghai upgrade, ETH prices broke through the USD 2,000 barrier for the first time in 8 months.

Investors and commentators are agreed that by expanding its transaction handling capabilities, beefing up its security, and slashing its energy overheads, the Merge has had major benefits for the Ethereum network and added to interest in the possibilities on offer.

Krungsri Research view: The Merge of Ethereum

Within the crypto world, the Merge was a major event on the 2022 calendar, and across the space, the success of the upgrade was closely tracked. This intense interest stemmed from the expectation that the Merge would achieve the difficult task of shifting the Ethereum blockchain into the sweet spot at the center of the blockchain trilemma, and by reducing problems with scalability, Ethereum would much better balance this with the other demands of security and decentralization.

From the point of view of the banking and finance industry, this upgrade to Ethereum’s capabilities brings with it significant benefits but also implies major impacts, too. With regard to the former, the Ethereum blockchain is already capable of supporting decentralized applications (DApps) and smart contracts, and combined with the network’s trustworthiness and decentralization, these offer an easy and convenient solution for processing a wide range of financial transactions. Moreover, because the smart contracts that are built on the Ethereum blockchain self-execute when specified conditions are met, this adds to efficiencies and reduces the risk that contracts can or will be amended after having been agreed. 

In addition, the very sharp cuts in electricity consumption that the Merge has enabled will serve to provoke greater interest from investors attracted by the promise of digital assets and who are focused on the development of Environment, Social, and Governance (ESG) goals. Within the blockchain universe, the Ethereum network is thus establishing itself as a leader in the field and is the choice for a ‘green blockchain’ for those interested in this area, and by occupying this position, the network will appeal to investors looking to push forward with the development of the industry and the generation of benefits for stakeholders. More generally, blockchain technologies are finding an ever-growing range of applications across the economy, including in the real estate sector, where their use is allowing for asset tokenization and for simpler document storage and exchange; the arts and entertainments industry, where blockchains can be used to encode artists’ rights, prevent copyright violations and ensure that payments are made directly to originating artists; and the health industry, where blockchains may be used to securely store patient records, easing bottlenecks created when individuals are seen in a number of different hospitals or clinics. Ultimately, blockchain technologies may be used to simplify and streamline work processes, and through this, reduce operating overheads. And with the introduction of PoS mechanisms on the Ethereum blockchain, this is now becoming an environmentally friendly option, too.