TLDR Summary
The Ethereum Merge, targeted for September 15 2022 is a migration of Ethereum’s consensus mechanism. Currently, under “Proof of Work”, miners validate transactions and secure the network. After the Merge, those staking Ethereum (locking ETH up like an interest bearing account) will validate the blocks, in a method called “Proof of Stake”
It’s called the Merge because it’s merging the current production Proof of Work Mainnet and the Proof of Stake Beacon Chain
The user experience will be unchanged. However, expect blockchain confirmation times to increase before they decrease to 12 seconds
Ethereum new supply will drop, thus reducing (and possibly even reversing) inflation
What are people doing?
Doing nothing and longing ETH
Taking ETH out of exchanges that don’t support forks, into a wallet like MetaMask to receive the airdrops of forked ETH
And other more complex trades (see below)
What is the Merge?
Vitalik first proposed the ideas of an evolution of Ethereum in 2013. Ethereum 2.0 was to alleviate congestion in anticipation of the much heavier network usage we see today. It has been repeatedly delayed, warranting the meme below, but perhaps the time has finally come.
Ethereum will soon undergo its most important transformation since the Mainnet launch. It’s called the Merge because it combines the Proof of Work blockchain (the “Mainnet” that was launched when Ethereum launched in July 2015) with the Proof-of-Stake blockchain (called the “Beacon Chain”). These two have run in parallel since the Beacon Chain was launched in December 2020. The PoS Beacon Chain becomes the Consensus Layer while the Mainnet becomes the Data and Execution Layer.
As a brief summary of what that means:
The Consensus Layer orders and agrees on which data comes first, and syncs the same state across the network of computers and submits transactions
The Data Availability and Execution Layer handles all the storage (wallet balances, applications, transactions, contracts), process transactions, smart contract interactions, block production and makes this data available
Primarily, the Merge is a move away from Ethereum’s consensus mechanism from Proof of Work to Proof of Stake. In PoW, miners validate transactions and secure the network. An attacker would have to purchase enough power and have access to the best hardware to achieve >50% of the computing power of the network. Under PoS, ETH holders posting collateral do that same job. If they misbehave, that collateral gets slashed. Currently, 11% of total ETH supply has been deposited for staking. To attack the network, someone would have to own >50% of the total staked amount (currently 13.5 million ETH, or $20.5 billion assuming the price of ETH doesn’t change or no one additionally stakes ETH to fight the attacker).
The restructuring of the consensus mechanism will also benefit Ethereum in the following key methods:
Appease the ESG crowd: the estimated reduction in energy consumption is 99.95%. The PoW method uses electricity and a hardware miner while the PoS method uses capital to secure the network.
Slow (or even reverse) ETH inflation: Block rewards (or new ETH tokens issued every block) will drop -90% from 2.0 to 0.2 ETH. Additionally, some amount of ETH gas fees will be burnt every block. Formerly, transaction gas fees paid in ETH just kept circulating between parties. This is analogous to a car’s “gasoline” never being burnt. In the previous method, a car going from A to B doesn’t burn gasoline but instead shifts the gasoline around. However, after the Merge, burning a portion of the gas fees would be akin to burning some gasoline, and therefore increasing the value of ETH due to increased scarcity. Furthermore, the net reduction of approximately 11,000 ETH daily removes about $16.5 million of sell pressure a day as miners need to cash out to take care of their operating expenses.
This month on August 11th, ETH core devs scheduled the Merge for Sept 14-15. Unlike previous forks, the schedule is not based on a block height but on the cumulative difficulty number. Before we get into that, let’s talk about the difficulty bomb.
What’s the difficulty bomb?
The difficulty bomb, recently encoded in the blockchain, increases mining difficulty in a step-up function. This forces miners to eventually stop using the PoW chain as the difficulty will tend towards infinity, and therefore the amount of energy required to mine Ethereum would continue increasing, ultimately rendering mining Ethereum unprofitable.
However, between now and the Merge with increased difficulty, blocktimes are also expected to increase. This is also intended to fire up Ethereum core devs to ensure the Merge happens ASAP because there’s no turning back now.
Why don’t we know when the Merge is exactly going to happen?
In aggregate, miners are currently rewarded ±13,000 ETH a day. These rewards will be completely eliminated and replaced by rewards of just ±1,600 ETH a day, distributed among those who stake ETH. To keep bad actors looking to “vampire attack” Ethereum’s ecosystem, core devs decided to trigger the merge at a certain difficulty number instead of a certain block.
Note: a vampire attack is when a protocol (or in this case, a blockchain) is copied by another. Then that identical or similar protocol tries to steal users by offering incentives (such as an airdrop)
In the past, events were triggered at a block number. While the Merge is on track for some time on September 15, it will be precisely triggered at a certain difficulty number of 58,750,000,000,000,000,000,000. A difficulty number (currently 17 digits long) is assigned to each Ethereum block and the summation of all these difficulty numbers is called the Terminal Total Difficulty (TTD).
This uncertainty in timing keeps attackers and those looking to fork a copy and “vampire attack” Ethereum in check. Bad-actor miners could mine a low-difficulty fork that would satisfy the block height requirement, but wouldn’t satisfy the TTD requirement. This way, there’s no confusion on which is the final PoW block at the time of the Merge.
Why would anyone want to fork Ethereum?
Miners won’t give up daily rewards of 13,000 $ETH without a fight.
Critics would say that it’s the same scammers who come out of the woodwork every time there’s an opportunity to support a fork and dump on retail. Bitcoin itself has over 100 forks. Many forks in the past promised to build and support the fork, and didn’t.
What will be the difference for the average user?
To keep miners from rebelling and to force them to upgrade, developers introduced the difficulty bomb. As difficulty increases, blocktimes will slow a bit, from ±13 seconds per block now to potentially doubling. However, post-merge, block times will drop to 12 seconds exactly.
After the merge, validators need to run their software with two modules for (a) execution and (b) consensus. The changes are only at the consensus layer, so for the average user, the experience is unchanged.
Why won’t an Ethereum fork succeed?
Ethereum’s value is in its ecosystem – the users, developers, apps, and infrastructure. Unlike Bitcoin, where Satoshi has gone dark for a decade, Vitalik is present and is indisputably Ethereum’s flag bearer. While the largest applications have pledged allegiance to Ethereum PoS’ chain, it is possible that some projects may choose the PoW chain. However, a chain is useless without users.
Now, users currently have their DeFi tokens, NFTs and outstanding contracts on Ethereum. They also enjoy bridges to other chains and may have wrapped assets. If a user has wrapped BTC, the $wBTC would only be recognized and redeemable for BTC from one version of Ethereum. A fork of Ethereum wouldn’t be able to duplicate $wBTC that is worth anything. Therefore, pricing of tokens, even if copied, wouldn’t necessarily make sense.
Also, if a user has a Bored Ape, forks of Ethereum wouldn’t be able to replicate that unique NFT. It wouldn’t benefit NFT creators to recognize replicas of their NFT on every ETH fork as it would diminish the value created due to uniqueness.
Furthermore, questions of infrastructure support remain such as – would popular wallets friendly to Ethereum support it? Will services that make a developer’s job easier – such as Remote Procedure Call (RPC) and Application Programming Interface (API) services – ecosystem support it?
A lot of variables make a successful Layer 1. It’s easy to launch a chain but difficult to create a vibrant ecosystem around it. There are plenty of tokens of zombie Layer 1s that are worthless as a result of the lack of ecosystem and developer, and community support.
So how are people positioning for the Merge?
Everyone should do their own research and figure out which side of the trade they’d like to take. Mostly, the popular trades are longing ETH in some form and benefiting from the fork airdrops. Expect the value of these airdrops to plummet quickly in a cloud of chaos once they’re released.
The bare minimum people are doing are:
Doing nothing and longing ETH, for HODLing
Taking ETH out of exchanges that don’t support forks, into a wallet that does (like MetaMask) to receive the airdrops of forked ETH.
More complex trades that people are looking at include:
If people want a leveraged play on the forks
Borrow ETH against USDC (or other stablecoin that aren’t supporting Eth forks) so that any fork airdrops can be sold
If people want some hedge and benefit from the forks
Long ETH and short ETC. ETC usually rallies before ETH forks and plummets after
Long ETH and short ETH futures or staked ETH. Unlike spot ETH, $stETH doesn’t receive airdrops
If people want a non-ETH trade
Long Lido ($LDO), Rocket Pool ($RPL), Ankr ($ANKR), Stakewise ($SWISE) which have approximately doubled from their year-to-date lows. Below is a graph of the largest players in the Staking business.
Source: Dune Analytics by sixdegree
Final comments…
Though the market is pricing the merge as highly likely and on-schedule, it’s not a given that the merge will successfully happen. That will depend on how great the devs are as this operation is one of the most complex – like fixing an airplane mid-flight. If the Merge doesn’t happen, it’ll be very negative for ETH sentiment and price as the market is looking forward to enjoying the benefits of Ethereum’s migration to PoS. However, ETH has outperformed BTC +50% since the bottom of the recent crash (June 19) and the market is pricing in a very successful merge.