By Rodrigo Zepeda, CEO, Storm-7 Consulting

Cumulative analysis of The Merge

In Part I of this ‘Ethereum (ETH) Merge’ Primer Series of blogs, we provided a background to the Ethereum platform and its originally envisaged range of potential applications, such as sub-currencies (token systems), financial derivatives, savings wallets, and ‘decentralized autonomous organizations’ (DAOs) (Ethereum 2013). We also summarised key blockchain and Ethereum concepts, namely proof-of-work (PoW), proof-of-stake (PoS), hard fork, the ‘difficulty bomb’, and the ‘Ice Age’. In Part II, we set out a brief evolutionary history of Ethereum developments which included earlier iterations of Ethereum, i.e., ‘Frontier’, ‘Homestead’, ‘Metropolis’.

We also identified the transition to the latest ‘Serenity’ iteration of the platform initiated in 2020, and we described the main technological elements of The Merge, in terms of sustainability, security, and scalability changes. In Part III, we explained the meaning and importance of gas prices, the conceptualisation of ‘Triple Halving’, the anticipated Ethereum ‘Shanghai’ upgrade, and the scheduled roll-out of Ethereum ‘Sharding’ and ‘Shard Chains’. Through this cumulative analysis, I hope that readers can now generally see why the event referred to as The Merge on the Ethereum network, scheduled to take place in September 2022, is somewhat complex for the general population to understand.

At its core, The Merge involves the existing Beacon Chain (which runs a PoS blockchain network) being merged with the existing Ethereum main network (mainnet) (which runs a PoW blockchain network). However, despite the plethora of technological complexities behind The Merge, the general idea behind it seems simple enough to understand once it is logically explained. Nevertheless, I would argue that in reality it is the envisaged ramifications of The Merge that seem to have made this occurrence so eventful. I will elucidate upon why I believe this to be the case.

Technological, financial, and business ramifications of The Merge

First, to begin with, The Merge itself represents an incredibly feat of technological engineering occurring on a massive, decentralised scale – this is a huge win for Ethereum’s developer community. Second, if The Merge is successful, it will show that a blockchain is capable of being successfully transitioned from a PoW to a PoS consensus mechanism at a global level. This in itself is no mean feat. Third, it should also show that the new Ethereum PoS network model is far, far, more energy efficient and environmentally friendly than a PoW network model.

In America, the White House only recently announced that crypto mining in the United States (US) was on track to use up as much energy as all of the country’s home computers, thereby precipitating the need for implementation of formalised power curbing measures (Emerson 2022). Essentially, energy usage by PoW crypto mining operations in the US has become so large, that it has become a national issue that now needs to be addressed via formalised governmental policy and legislation. As a result, The Merge may call into question the long-term commercial viability of existing tokens such as Dash (DASH), Litecoin (LTC), Monero (XMR), and ZCash (ZEC), all of which rely on legacy PoW consensus mechanisms.

The question is, would you really want to invest in PoW cryptocurrencies whose future long-term growth and intrinsic value is predicated on increasingly damaging the planet (i.e., as the token grows it relies on more and more energy which generally results in higher and higher carbon emissions)? In the short term, the people behind PoW tokens, PoW mining operations, and PoW investment firms, as well as investors, will all naturally scramble around desperately trying to vehemently criticise or undermine PoS models, in a bid to retain market shares, credibility, and existing investment value. However, in all likelihood, in the long-term this will turn out to be a losing battle.

Fourth, with the transition from a PoW to a PoS model, and the final stretch in the multi-phased roll-out of the Consensus Layer (Ethereum 2.0) in 2023/2024, Ethereum will now be seeking to aggressively address its existing criticisms and deficiencies to facilitate extensive growth and dominance of its ecosystem. On 30 July 2020, Ethereum marked its fifth anniversary, and at this point there were around 200,000 active developers building on the Ethereum platform (Millman 2020). Developer activity is one of the most important factors for blockchain growth, i.e., a leading indicator of a blockchain’s long term health and prospects (Lemmens 2022).

One way of looking at it, is if you view ‘total value locked’ (TVL) (amount invested into a blockchain) as the global market ‘demand’ (made up of people and price), then developers can be viewed as the ‘supply’ (the ones who develop more blockchain applications (Apps)) (Lemmens 2022). To support robust long-term growth, strong increasing demand must be met by continuing and innovative supply of Apps by developers. In 2021, the top five biggest developer-led blockchain ecosystems in order were:

(1) Ethereum (ETH);

(2) Polkadot (DOT);

(3) Cosmos (ATOM);

(4) Solana (SOL); and

(5) Bitcoin (BTC) (Lemmens 2022).

At that time, the Ethereum platform (n=4,011 mean monthly developers) had 2.8 times more blockchain developers than the next highest, the Polkadot platform (Lemmens 2022). In that comparatively short space of time, Ethereum had already become the world’s most widely used blockchain featuring a global decentralised ecosystem of developers, platforms, and users (Cryptopedia 2021). In fact, the Ethereum network played a central role in the Initial Coin Offering (ICO) boom of 2017 and 2018, and it is now home to a very broad range of crypto tokens, decentralised finance (DeFi) Apps (DApps), non-fungible tokens (NFTs), smart contract applications, and stablecoins (Cryptopedia 2021).

Ethereum has also played a pivotal role behind the NFT boom of 2021, as most major NFT online platforms such as Foundation, Mintable, Nifty Gateway, OpenSea, Rarible, and SuperRare, use the Ethereum platform to mint and host NFTs, and the ETH token to buy or sell NFTs (Singh 2022; Kimani 2022; Hayward 2022). Consequently, in practice, by addressing and significantly improving its sustainability, security, and scalability post-Merge, the Consensus Layer should be able to facilitate expansive growth in developers utilising the Ethereum blockchain, with a concomitant rise in DeFi and smart contract Apps in the coming years (Butler 2022). This may prove to be highly instrumental in pushing Ethereum towards cementing its place as the world’s most widely used blockchain platform.

The DeFi sector is extremely fast-growing and is still very much in its infancy, with disruptive DeFi tools such as Argent, Eidoo, Keycard, MathWallet, Synthetix, and Uniswap, being developed every day (Millman 2020). The future potential of smart contracts is even bigger. Examples of future smart contract use cases include corporate structures; digital identity; emerging technologies; enterprise systems; escrow; financial data recording; financial security; financial services; government; insurance; legal contracts; medical research and clinical trials; mortgages; off-chain computation; peer-to-peer transactions; product development; property ownership; supply chain management; sustainability; trade finance; trading activity; and utilities (Chainlink 2020; Geroni 2021; Davies).

Consequently, the use of the Ethereum blockchain to develop this potentially huge range of next-generation smart contract applications and industries, will very likely lead to a significant attendant increase in Ethereum global market share, and a significant attendant increase in the value of the native cryptocurrency Ether over time. In the next five to seven years, whichever crypto platform secures market share and/or control over DeFi and smart contracts apps, will very likely become the de facto leading crypto platform in the world.

The co-founder of Ethereum, Vitalik Buterin set out six areas which would enable the Ethereum platform to become better than the Bitcoin platform in the future (Hamacher 2020). The first area was Ethereum ‘Sharding’ (covered in Part III) and ‘zero-knowledge proofs’ (ZNPs), which would together ensure that verification of transactions and individuals would be much more cost effective (Hamacher 2020). A ZNP is a way of proving the validity of a statement without revealing the statement itself (Ethereum (zero-knowledge proofs)). In practice, ZNPs could help to facilitate anonymous payments, authentication, decentralised identity protection, and verifiable computation (Ethereum (zero-knowledge proofs); Goldwasser, Micali, and Rackoff 1989).

The second area was PoS (a massive improvement over PoW); the third area was stateless verification (i.e., much faster, more secure, and cheaper authentication); and the fourth area was the extensive support provided for arbitrary smart contracts on the updated Consensus Layer (Hamacher 2020). The fifth area was the increased support provided for strong privacy at Layer 2 (L2), and the sixth area was the new 12 second interval block issue time under PoS (Hamacher 2020). Previously, Ethereum block issue times under PoW were 13 or 14 seconds (this can be compared to Bitcoin issue times which are an average of 10 minutes (Kessler and Young 2022).

From a snapshot perspective, there are currently more than 3,000 DApps running on the Ethereum blockchain; more than $34.2 billion TVL in smart contracts; over $16.05 billion TVL in the DeFi space; and over $5.3 billion ETH staked (Hertig 2022; Pechman 2022). In the future, the expected huge increase in DApps and smart contracts; the proliferation of Ethereum hosted NFTs and NFT platforms; the proliferation of DeFi markets via institutional and retail investor staking, lending, and other activities; and Buterin’s six Ethereum areas; will all very likely contribute to facilitating extensive growth and dominance of the Ethereum ecosystem worldwide.

Fifth, Ethereum’s positioning post-Merge means that it will be set to increase its global market capitalisation, perhaps with a view to gaining the ultimate title of ‘Bitcoin Killer’, i.e., the altcoin that de-thrones Bitcoin as the number one cryptocurrency in the world. A reference to ‘Ethereum Killer’ is therefore a reference to an altcoin that is able to out-compete the Ethereum platform and ETH, thereby de-throning Ethereum as Bitcoin’s top competitor. Ethereum cryptocurrency market capitalisation is a function of the number of coins in circulation by the ETH market price.

In light of the onset of Triple Halving, and the decline in total supply following on from The Merge, the market value of Ethereum must increase if its total market capitalisation is to increase. Historically, the problem with Ethereum has been that the ETH inflation rate has been steadily increasing since its launch (Wood 2022). This is in stark contrast to BTC, which has exhibited a much lower inflation rate in conjunction with a theoretical cap on total supply, i.e., 21 million BTC (Wood 2022). BTC’s intrinsic tokenomics and supply transparency has contributed to its long term price increase (Wood 2022).

However, in a post-Merge world, Ethereum’s fundamentals will change, as total ETH supply will decrease, more and more token holders are likely to stake ETH to generate additional income (because of the transition to a PoS model), leading to increased total market interest (Wood 2022). The expected decrease in the total supply of ETH in the short term is likely to lead to an increase in the value of ETH, as well as providing a boost to Ethereum’s investment potential (as a store of value and a hedge against inflation) (Wood 2022).

It is also likely that the value of ETH will increase as more and more people become PoS validators by staking ETH, i.e., because of an increased range of staking methods – solo home staking, staking as a service, pooled staking, centralised exchanges (Ethereum (staking)). Once The Merge is complete, Ethereum will then enter into its final stages of its latest network upgrade, followed by the Shanghai update and Ethereum Sharding and Shard Chains. This Ethereum network optimisation is expected to lead to increased long term investment, such as by large institutional investors (e.g., endowments, family offices, hedge funds, pension funds), and by venture capital investors in new Web3 projects (Wood 2022).

The Merge therefore represents one of the final long-awaited steps that the Ethereum network needs to begin to function at near ‘full capacity’. What does such near full capacity look like? Well, it would feature a decentralised blockchain system based on an energy efficient and environmentally friendly PoS consensus mechanism with a highly extensive network of validators (ETH stakers), and which features scaling hyper-efficiency at two levels via Sharding and Shard Chains, and via L2 roll-up efficiencies.

In practice, it is likely that in order to reach near full capacity the Ethereum network will take between one to two years. In the meantime, Ethereum will still have to contend with the proliferation of stablecoins and central bank digital currencies, the continuing global dominance of Bitcoin, and the rapid evolutionary trajectory of a range of new Ethereum Killer altcoins such as Avalanche (AVAX), Cardano (ADA), Polkadot, Solana, and Tezos (XTZ). In recent years, Ethereum’s top competitors have been able to rapidly onboard new users because of Ethereum’s high gas fees and low transaction speeds (DeMatteo 2022; Stevens 2022). Once Sharding and Shard Chains are implemented post-Merge, Ethereum should finally be able to compete at a more advanced level with its Ethereum Killer competitors. As such, 2023 should prove to be a highly eventful year in terms of the global battle for cyptocurrency, DeFi, NFT, smart contracts, and Web3 markets.

I hope readers of this ‘Ethereum (ETH) Merge’ Primer Series of blogs now have a better understanding of key Ethereum project foundational concepts such as difficulty bomb; Ethereum Killers; hard fork; Ice Age; PoS; PoW; Shanghai upgrade; Shard Chains; Sharding; Staking; Staking Rewards; and Triple Halving. I also hope that it has provided readers with a better understanding of what The Merge is; what changes it will introduce; why it is viewed as being so important in terms of Ethereum’s evolutionary trajectory; and the expected or likely short term and long term technological, financial, and business ramifications of The Merge.