The cryptocurrency market: what you need to know about the Ethereum network “merger”

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Since the publication of the first Ethereum whitepaper in 2014, Ethereum developers have made it clear that they want to eventually implement the Ethereum network protocol. proof of stake In place proof of workhowever, due to technical difficulties, this has not been possible so far.

Ropsten’s current testnet will merge on the same day. If the connection to the Ropsten network is successful, the Ethereum network will connect two other test networks that already exist before the actual merger. Given this news and information from the Ethereum Foundation, there are indications that the merger will take place in August, provided the tests go well. As the merger will take place in the near future, let’s discuss how it will transform the Ethereum network both technically and economically.

The most important modification will be the passage of the protocol proof of work on proof of stake, which will fundamentally change the method by which the network verifies transactions. Instead of the massive computing power made available to the network by cryptocurrency miners, ether owners will verify the transaction.

This means that they will have the ability to lock Ethers as collateral so they can verify transactions – in other words, stack the Ethers they have. In return, they will receive transaction fees as well as security fee coverage. For now, under the financial incentive for miners, costs will be covered in the form of newly issued Ethers, while later this will be directly applicable to stackers for transaction verification. The main advantage of the protocol proof of stake in terms of security, the participants are subject to strict control. In the event that the network determines that a stacker has acted unethically – for example, they tried to reverse a transaction – the network may withdraw some or all of their stacked ethers.

After implementing the protocol proof of stake, the Ethereum network will reduce power consumption by approximately 99.95%. To understand why this happens, you need to re-examine the differences between consensus mechanisms. For the Ethereum network, a new block is now finalized approximately every 13 seconds. During those 13 seconds, each miner scrambles to be the one to finalize the block. It consumes computing power and therefore requires electricity. Ultimately, however, only one miner finalizes the block and verifies the transactions, even though others have spent huge amounts of energy on the same block. As part of the protocol proof of stake, a validator is randomly selected to finalize the block based on the number of stacked ethers. This happens before the block is created so that no other stacker tries to finalize the same block, which ultimately reduces the power consumption of the Ethereum network by around 99.95%.

Due to the drastic decrease in the amount of energy needed to verify transactions on the Ethereum network, security costs can also decrease significantly. As part of the protocol proof of work the costs of securing the Ethereum network amount to approximately 5.4 million ETH per year.

This means that 5.4 million new Ethers are issued each year, up to the current supply of around 120 million Ethers to encourage miners to verify the transaction. At the time of the merger, security costs will drop to around 0.5 million ETH per year in compensation for the stackers. This is a significant reduction in Ethereum inflation that could even lead to deflation, as transaction costs paid are expected to exceed Ethereum hedging costs. With regard to transaction costs, a significant part will be “burned” and therefore removed from the offer. Over time, this can create a supply shock as the market is used to absorbing 5.4 million newly issued Ethers per year, when suddenly only around 0.5 million Ethers need to be issued.

It could also be argued that the protocol proof of stake is fairer to ethereum holders economically than proof of work. In the case of protocol proof of work you can de facto verify transactions without the need for ethers, as long as you invest heavily in processing power. This means that ETH holders are not compensated for inflation or transaction fees, which dilutes the cryptocurrency. In the case of protocol proof of stake holders are fairly rewarded with inflation and transaction fees.

The merger as such will not make the Ethereum network much more scalable. If successful, this will reduce the block creation time from around 13 seconds to 12 seconds while maintaining the same block size. Ultimately, this will increase trading efficiency by 7.5%, but not much more. According to the current schedule, the scalability of the Ethereum network will not improve until 2023. Eventually, shard chains (fragmentation) will be implemented at this time, which will greatly improve the scalability of the Ethereum network and may require even less hardware to verify transactions.

On December 1, 2020, the version of the Ethereum network using the protocol was launched proof of stake, known as the Beacon Chain. Beacon Chain is the version that will be realistically connected to the Ethereum network based on the protocol proof of work at the time of the merger. As soon as it starts, Beacon Chain finalizes the empty blocks to ensure that it works as expected. For verification of these blocks, Ethereum holders were able to stack Ether as part of the Beacon Chain. Currently, the Beacon Chain stores more than 10% of the total Ether supply, or approximately 12.8 million ETH.

However, by stacking ethers in the Beacon chain, these ethers were blocked. Originally, it was planned to release the stacked ethers at the time of the merger, but to technically simplify the merger process, the Ethereum network developers decided not to release the stacked funds at this date. The release will likely take place 6 months after the merger and will cover the amount of 12.8 million stacked ETH and Ether at a later date. During these months, funds will also be blocked to cover security costs and transaction fees for stackers.

This means that – presumably by next year – no newly issued ETs or transaction fees are expected to come into circulation, potentially reducing the pressure on sales. On the other hand, when stacked ethers are released, the amount of which can even exceed 15 million ETH, it can put a lot of pressure on sales.

The merger will not affect the Ethereum network in any other significant way. First, it should not affect ETH holders or require any activity from them. The connection will be made transparent to ETH holders. Second, it should not affect tokens or affect decentralized applications currently using Ethereum. This means that tokens and smart contracts on the Ethereum network will work as before the merger.

Although Ethereum network developers have been working on the merger for years, the merger may fail or be further delayed. As with every other aspect of the cryptocurrency market, there are simply no guarantees.

Mads Eberhardt, Cryptocurrency Market Analyst, Saxo Bank

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