The ‘Ethereum (ETH) Merge’ Primer Series: PART I

By Rodrigo Zepeda, CEO, Storm-7 Consulting

Introduction

This ‘Ethereum (ETH) Merge’ Primer Series of blogs, will seek to describe what the event referred to as ‘The Merge’ is, and why it is so relevant and important to the overall evolution of the Ethereum platform. It has now been proposed that The Merge is scheduled to commence on Thursday 15 September 2022. The Merge represents one of the most important milestones for the Ethereum project undertaken to date, and it will invariably have important repercussions in terms of, not only the technological features offered by the Ethereum blockchain network, but also the price of its native platform cryptocurrency. 

The inherent difficulty, however, is that to fully understand what The Merge is, as well as its technological, financial, and business implications, it is first necessary to understand all key foundational concepts underlying the Ethereum project. In addition, if people wish to invest in the native cryptocurrency, they will surely need to understand how The Merge will impact Ethereum’s platform and technical fundamentals. Consequently, this 'Ethereum (ETH) Merge' Primer Series of blogs will seek to provide readers with a solid background briefing on all such key foundational concepts upon which the Ethereum project is based.

It will also set out what the Ethereum Merge is, what changes it will introduce, and why it is viewed as being so important in terms of the overall evolution of the Ethereum platform. It will explain to readers the meaning and importance of concepts and terms such as Ethereum ‘Sharding’ and ‘Shard Chains’, Ethereum ‘Shanghai’, Ethereum ‘Triple Halving’, Ethereum Staking and Staking Rewards, and Ethereum ‘Killers’. In addition, it will seek to analyse what are the expected or likely short term and long term technological, financial, and business ramifications of The Merge.

Introduction to Ethereum

Ethereum is a decentralised, open-source, blockchain-based software platform that features smart contract functionality and a native platform cryptocurrency, namely ‘Ether’ (ETH). The Ethereum platform was originally launched in 2015 by co-founders Amir Chetrit, Anthony Di Iorio, Charles Hoskinson, Gavin Wood, Jeffrey Wilcke, Joseph Lubin, Mihai Alisie, and Vitalik Buterin. In a very short space of time the Ether cryptocurrency has risen to become the second largest cryptocurrency in the world, ranking only behind Bitcoin (BTC).

As of 2 September 2022, the value of ETH was priced at approximately $1,590.85 with a total market capitalisation of $194,413,024,351 (CoinMarketCap (ETH) 2022). This can be compared to the value of BTC which was priced at approximately $20,096.42 with a total market capitalisation of $384,610,638,288 (CoinMarketCap (BTC) 2022). So, in terms of value there is clearly a large difference between that of BTC and that of ETH. However, it should be remembered that the value of ETH reached an all time high in 2021, when it was valued at approximately $4,811. This means that it is currently trading at $3,220.15 below its all time high trading price.

Many crypto market participants believe that The Merge will very likely result in an increase in the current market trading value of ETH in September 2022. In contrast to Bitcoin, one of the most significant and important points to note about Ethereum is the technological functionality that is featured within the platform. The Ethereum whitepaper published in 2013 provides an overview of the envisaged functionality of the Ethereum platform (Ethereum 2013). Ethereum was designed to be a next-generation smart contract and decentralised application (DApp) platform with envisaged potential applications such as:

(1) sub-currencies (token systems);

(2) financial derivatives;

(3) identity and reputation systems;

(4) ‘decentralized autonomous organizations’ (DAOs);

(5) savings wallets;

(6) crop insurance;

(7) de-centrally managed data feeds;

(8) smart multi-signature escrows;

(9) peer-to-peer (P2P) gambling;

(10) full-scale on-chain stock market;

(11) on-chain decentralised marketplace; and

(12) a decentralised dropbox (Ethereum 2013).

As will be explained in later parts of this blog series, it is the creation, development, and evolution of these types of next-generation applications on the Ethereum platform that will very likely lead to a significant attendant increase in the value of the native cryptocurrency Ether over time. As a result, it is this intrinsic functionality that most clearly differentiates Ethereum from Bitcoin, because the more sophisticated Ethereum becomes, the greater the probability that ETH will increase in value, i.e., the value of ETH is arguably reflected in both cryptocurrency (money) factors and platform functionality factors.

Key blockchain and Ethereum concepts

There are a few key blockchain and Ethereum concepts that need to be briefly explained in order to better understand the history of Ethereum developments that have occurred to date that will be covered in the next Part.

Proof-of-work (PoW)

The network of computers that lies behind any blockchain and cryptocurrency can be referred to as a ‘consensus mechanism’, and they govern elements pertaining to transactions and security. A reference to ‘proof-of-work’ (PoW) is a reference to a type of consensus mechanism that cryptocurrencies use to verify new transactions and to create new tokens within the blockchain network. In a PoW consensus mechanism, the verification of cryptocurrency transactions and the adding of such transactions to a blockchain’s public ledger is undertaken via blockchain ‘mining’.

Mining refers to a miner utilising a network of computers running blockchain software (nodes) to complete ‘work’ on behalf of a relevant blockchain. The work essentially consists of the solving of cryptographic puzzles in order to validate transactions and earn block rewards (hashing) (Antolin 2022). The miner that solves these puzzles the fastest is awarded the block rewards, and so mining generally requires a significant amount of energy to operate a network of computers (Antolin 2022). The PoW protocol therefore relies on computational power and cryptography to create consensus on a blockchain, i.e., a cryptocurrency.

The difficulty is that as the cryptocurrency grows more and more power is used by virtual miners around the world to mine the cryptocurrency. There is also significantly increased competition that occurs because of increases in the value of the cryptocurrency over time. Bitcoin is an example of a cryptocurrency that is based on a PoW protocol. The current iteration of the Ethereum blockchain network is based on PoW and was referred to as ‘Ethereum 1.0’ (or ‘Eth1’). However, from January 2022 onwards, Ethereum 1.0 was supposed to be referred to as the ‘Execution Layer’, although the terms are now still (confusingly) used interchangeably.   

Proof-of-stake (PoS)

The term ‘proof-of-stake’ (PoS) refers to the second main consensus mechanism used by cryptocurrencies. In a PoS protocol, validation of blockchain transactions is carried out by ‘validators’ which are chosen based on different underlying rules that reflect a ‘stake’ that a validator holds in the relevant blockchain (Antolin 2022).  A PoS protocol significantly reduces the amount of computational power required by nodes to verify transactions. This is because validators are instead randomly selected based on the cryptocurrency stake that is staked in order to enter into the selection (mining) process.

In this way, a PoS protocol seeks to avoid both the heavy energy usage costs required to constantly run PoW blockchain mining equipment, and the heavy investment costs required to set up PoW blockchain mining operations in the first place. Investors need only invest in the minimum required stake in a cryptocurrency to become a validator. PoS protocols are much more energy efficient and are generally believed to be safer and more acceptable in terms of the environmental impact of cryptocurrency mining.

In addition, the PoS model is designed to reduce transaction fees on the blockchain network, improve scalability of network operations, and significantly improve available security features. New cryptocurrencies such as Avalanche (AVAX), Binance Coin (BNB), Cardano (ADA), Cosmos (ATOM), Polkadot (DOT), and Tezos (XTZ), all generate new blocks through a PoS protocol. The next iteration of the Ethereum blockchain network will be completely based on PoS and was originally referred to as ‘Ethereum 2.0’ (or ‘Eth2’). From January 2022 it was supposed to be referred to as the ‘Consensus Layer’ (or ‘Serenity’) (Millman, Graves, Kelly 2022).

Hard fork

At its most basic, a 'fork' refers to the modification of open-source code that is hosted on a blockchain (i.e., a change to a blockchain’s protocol), and it comes in two forms, namely a 'soft fork' and a 'hard fork' (Acheson 2022). With a soft fork, any newly implemented changes on a blockchain will remain backward compatible with older versions – this is because the end result is a single blockchain, so all new changes remain compatible with pre-fork blocks (Coinbase; Acheson 2022). However, with a hard fork, the new change that is introduced to the blockchain is so extensive that the new version is not backward compatible with older versions – the end result is a split in the blockchain protocol so that there are two branches in the network (Coinbase; Acheson 2022).

One branch follows the previous protocol, and the other branch follows the new protocol that has been implemented which will follow a new set of operational rules, i.e., node operators upgrade to the latest version of the protocol (Cointelegraph). Hard forks may occasionally happen by accident, however, in general they are intentional in nature and are implemented in order to add functionality, correct security risks, reverse existing blockchain transactions, or to resolve any blockchain community disagreements (Cointelegraph). Hard forks may sometimes result in two different cryptocurrencies being developed, e.g., Ethereum and Ethereum Classic (ETC) developed in July 2016.

The Ethereum ‘difficulty bomb’

What has been referred to as the Ethereum ‘difficulty bomb’ is a reference to an algorithm that was designed to increase the difficulty of mining Ethereum blocks over time (ConsenSys 2020). At a pre-defined number block, the difficulty bomb was originally supposed to set in and gradually increase the difficulty level of solving puzzles in the Ethereum PoW algorithm model, which would result in block times taking longer than normal to mine (Kessler and Young 2022). One of the ideas behind the difficulty bomb, was that the encoding of this algorithm within the Ethereum platform would normalise the idea of upgrading the blockchain network (ConsenSys 2020).

Normally, coordination costs that are associated with network upgrades are costly, and so blockchain projects had previously sought to avoid them (ConsenSys 2020). However, because the Ethereum project was developed under the ethos of ‘continuous innovation’, the difficulty bomb was encoded into the project in order to force the implementation of regular hard forks in the Ethereum blockchain (ConsenSys 2020). In this way, it was envisaged that frequent upgrades to the blockchain would be required.

Consequently, the coordination costs were intended to form a necessary cost of securing the continuous innovation required as part of the Ethereum project. Another idea behind the difficulty bomb was that it provided an artificial incentive for implementing The Merge within the Ethereum network (Kessler and Young 2022). Once the bomb is set off, the speed of the network begins to slow down. The introduction of the difficulty bomb within the Ethereum 1.0 network was originally intended to herald the coming of the Ethereum ‘Ice Age’.

The Ethereum ‘Ice Age’

The Ethereum ‘Ice Age’ technically refers to a hard fork of the Ethereum blockchain network at block 200,000. This was intended to introduce an exponential difficulty in the PoW block mining algorithm (difficulty bomb), which was designed to catalyse a transition from a PoW to a PoS network. In theory, once the difficulty bomb is introduced, the difficulty of mining Ethereum blocks will increase exponentially, meaning that mining will become so difficult that it will invariably come to a halt, leading to a freezing of all mining production, i.e., entering into the Ice Age.

One of the main points to note here, is that the hardware used by Ethereum 1.0 miners when mining Ethereum blocks under the PoW model will not be required in the Ethereum 2.0 PoS model. It was originally envisaged that the introduction of the difficulty bomb would very quickly make it unprofitable for miners under the Ethereum 1.0 PoW mining model (Ayllon 2020). Because of this, as the difficulty bomb makes Ethereum 1.0 PoW mining more and more difficult, and as more and more Ethereum 1.0 miners give up mining Ethereum 1.0 blocks, a transition to the Ethereum Ice Age will occur (to be replaced by the Ethereum 2.0 network) (Ayllon 2020).

TO BE CONTINUED