Last Updated: 9/14/2022 | 7 min. read
Background on the Merge
Ethereum transitioned to Proof of Stake (PoS) on the morning of September 15, 2022 at approximately 2:43 am, marking a significant milestone in an eight year long effort to increase the efficiency and scalability of the network. The Merge is a historic event for Ethereum, effectively upgrading the network’s combustion engine to a modern electric motor.
For years, the Merge has been repeatedly delayed as developers worked through the technical and social challenges facing an upgrade of this magnitude. The Ethereum network today boasts a market cap of nearly $200 billion[1] with more than $23.7 billion[2] in token value locked on the network, leaving very little room for error. In the words of the Ethereum Foundation:
“Imagine Ethereum is a spaceship that isn't quite ready for an interstellar voyage. With the [Merge], the community has built a new engine and a hardened hull. After significant testing, it's time to hot-swap the new engine for the old mid-flight.”
What Investors Should Know
The new Proof of Stake engine powering Ethereum differs from the old Proof of Work engine by selecting who has the right to confirm the next block (rather than through competition amongst miners). In the new PoS consensus mechanism, validators must stake in increments of 32 ETH (~$51,000[3]) to become eligible to confirm blocks for rewards. Users can participate in earning yield by staking Ether with validators, with no minimum.
While the inflation rate was previously fixed at 2 ETH per block or 3.8%[4], it will now vary depending on the number of validators on the network. Immediately following the Merge, the block reward dropped to approximately 0.23 ETH[5] per block, resulting in more than 100 ETH[6] removed from the supply in 10 minutes.
Prior to the Merge, staking yield was approximately 5%, consisting solely of the 0.23 ETH block reward. Staking yield is expected to increase now that validators are responsible for verifying transactions and earning the transaction fees for doing so.
A common misconception surrounding the Merge is that transaction fees on Ethereum have been reduced. The parameters for how transaction fees are calculated has not significantly changed, and therefore fees will continue to be a product of network congestion.
Why the Merge Matters
While it’s still early, we are beginning to see some optimistic shifts in the economics of the network for ETH holders. In addition, the supply of ETH could potentially become deflationary due to the fee burn from EIP-1559, implemented a year ago in August 2021.
For example, in the past seven days (pre-Merge), the network burnt approximately 10.5%[7] of the block reward (or approximately 0.2 ETH per block). While the inflation rate of the network has since decreased, the burn mechanism remains the same. The significant reduction in block reward increases the likelihood of the ETH burn being larger than the block reward, resulting in a net decrease in ETH token issuance.
What's Next for Ethereum
The Merge brings some welcome upgrades to inflation, staking yield, and energy efficiency of the network; however there is still more work to be done. While staking yield has become more attractive, staked ETH will remain locked until the Shanghai Upgrade, expected several months from now. It also sets the stage for the next major scalability upgrade — sharding — which is expected to significantly improve the transaction throughput and scale of the network.
Glossary
- Proof of Work (PoW) – a consensus mechanism in which miners expend computational resources to compete to validate transactions and are rewarded coins in proportion to the amount of computational resources expended.
- Proof of Stake (PoS) – a consensus mechanism in which validators (known as miners in Proof of Work) risk or “stake” coins in order to be randomly selected to validate transactions and are rewarded coins in proportion to the amount of coins staked.
- Validator / Validating – the stakeholder in a proof of stake network that confirms blocks on the blockchain in exchange for rewards.
- Staker / Staking – users who lock up tokens with a validator to participate in confirming blocks in exchange for a share of rewards.
- Block Reward – the payment to the user validating transactions on a blockchain consisting of transaction fees and newly minted tokens.
- Blocks – subunits of a blockchain containing transactions.
- Staking Rewards / Yield – the earnings generated via block rewards for contributing to confirming blocks on the blockchain.
- EIP 1559 – A transaction pricing mechanism that includes fixed-per-block network fee that is burned and dynamically expands/contracts block sizes to deal with transient congestion.
[1] Source: Coinmarketcap as of September 15, 2022 at 2:35 am EST
[2] Source: Defillama as of September 15, 2022 at 2:35 am EST
[3] Source: Coinmarketcap as of September 15, 2022 at 2:40 am EST
[4] Source: Coin Metrics as of September 14, 2022 midnight close
[5] Source: Beacon Scan as of September 14, 2022 midnight close
[6] Ultrasound.money as of September 15, 2022 at 3:13 am EST
[7] Watch the Burn as of September 15, 2022 at 2:35 am EST
