We are just months away from the long-awaited update to The Merge, which will be a milestone in Ethereum's development. Not only will the consensus algorithm change - ether will become more environmentally friendly and deflationary, which could have a positive effect on its price in the medium and long term.


We looked into the specifics of the upcoming upgrade and its potential impact on the investment appeal of the second most capitalized cryptocurrency.

• The final preparations for Ethereum's transition to the Proof-of-Stake consensus algorithm during the activation of The Merge upgrade remain to be made.
  
  
• The upgrade will significantly affect the cryptocurrency's fundamental qualities, making it deflationary and much more environmentally friendly.
  
  
• The price-affecting rate of ether issuance will depend on the number of validators and onchain activity.
  
  

The seven-year path.

The transition from Proof-of-Work (PoW) to Proof-of-Stake (PoS) is the most important and complex upgrade in Ethereum's history. The seven-year-long process has reached the finish line.


In the past, the upgrade has been variously called Serenity, Casper, Shasper, Ethereum 2.0, and finally The Merge.


The upgrade will change the consensus mechanism that defines the principles of transaction validation and block release.



Since 2014, developers have been exploring PoS as an alternative to PoW systems. Due to the novelty and insufficient study of the then-new algorithm, ether was launched in 2015 based on Ethash technology, which relies on Proof-of-Work.


In the same year, the developers presented an ambitious roadmap, where the final stage of development was called Serenity. It envisioned a complete transition from Ethash to a stable PoS algorithm.


One of the main motives is to improve Ethereum's energy efficiency. The developers expect that thanks to The Merge, power costs will be reduced by more than 99.9%. Instead of miners, validators will play a central role in the network, each requiring 32 ETH in collateral.


According to Galaxy Digital Research, the upcoming upgrade will not change the algorithms of user interaction with dapps in any way. Customers of exchanges, custodial services, and regular ETH holders will not be required to move their coins anywhere.


From inflation to deflation

Currently, most of the new Ethereum issuance is happening in the traditional PoW blockchain, the execution level. Miners receive 2 ETH per mined block - a total of over 12,000 ETH per day.

Data: IntoTheBlock

A small portion of ETH is released on the Beacon Chain. This PoS-based network is called the consensus layer.

The launch of the Beacon Chain (or phase zero of Ethereum's second version) took place on December 1, 2020.

The number of ETH issued at the consensus level varies depending on the number of validators and the volume of coins in the stack. Another factor affecting issuance is the burning of a portion of transaction fees depending on network load. This mechanism

(EIP-1559) was activated in the London hardforge, since which more than 2.4 million ETH have been burned.

Data on Ethereum inflation and volume of coins burned since EIP-1559 activation. Data from ultrasound.money as of June 8, 2022.

With the current 12.7 million ETH in stacking (about 10% of the market supply of ether) and a daily burn rate of 7,900 ETH, inflation would be 2.1%. In other words, the annual volume of new issuance would be approximately 5.4 million ETH.

ETH supply distribution graph: funds, ETH2 stacking, DeFi, exchanges reserves. Data: CryptoQuant.

The following screenshot is a heatmap. It shows how changes in the rate of combustion and the volume of stacked ETH at the consensus level affect the daily volume of Ethereum issuance.

After the activation of The Merge, the emission mechanism no longer assumes a fixed reward to miners per block. The amount of ETH rewarded to validators will change dynamically, each epoch lasting 6.4 minutes.

Let's assume 11 million ETH are involved at the consensus level. The heatmap above shows that this parameter would produce 1,511 ETH per day.

If we take into account coin burning - for example, 4,000 ETH per day - Ethereum will become deflationary. The supply volume under such parameters will decrease by 2,489 ETH per day, or 0.77% per year.

The volume of ETH being burned is directly dependent on onchain activity, which is on the decline after the hype around DeFi and NFT is over. The chart below shows that the number of transactions on the Ethereum network has dropped significantly from its May 2021 peak. The daily figure is below the 1 million mark, which corresponds to the values of early 2018.

Data: IntoTheBlock.

"If user adoption of Ethereum goes up in the coming months and years after the Merge upgrade, the supply of ether will shrink even faster," Galaxy Digital Research experts stressed.

Then, they said, the value proposition of the second most capitalized cryptocurrency will intensify, especially in the context of a means of preserving value.

As already mentioned, PoS network security is not provided by energy-intensive miners, but by validators, which block collateral in the form of ETH in the network. The more coins in the stack, the harder it is for a potential attacker to gain control of the system and alter transaction history.

Ethereum's consensus level is designed so that rewards to validators are automatically adjusted based on the amount of ether involved.

Annual ETH issuance vs. annual validator yield. Data: Galaxy Digital Research.

When the number of ETH in stacking is growing and there are many validators active in the network, the latter's yield decreases. In the opposite situation, when there are few validators and coins in stacking, the yield rises to encourage their more active participation in the network.

As of June 8, 2022, there are 399,554 validators.

Growth dynamics of the number of accounts that deposited 32 ETH into the Ethereum 2.0 deposit contract. Data: Glassnode.

Algorithmically varying issuance rates ensure that regardless of the amount of ETH in the stack, validators are always sufficiently motivated to work.

"However, this dynamic approach is fraught with difficulties when it comes to predicting Ethereum's monetary policy over the long term," Galaxy Digital Research experts stressed.

In addition to the number of ETH in stacking and the number of coins burned, analysts should also consider less relevant metrics: online validators and those subjected to slashing.

Data: Galaxy Digital Research, ultrasound.money.


The graph above illustrates the projected decline in ETH supply after the activation of The Merge. According to Ultra Sound Money, with 2.9 million ETH burned per year (or about 8,000 ETH per day, which is the average since the activation of EIP-1559), the number of coins in circulation will decrease by 2% per year.


Other factors will also affect the revenue structure:

• Priority commissions that Ethereum miners currently receive will go to active validators once The Merge is activated. According to Coin Metrics, the total amount of such "tips" is just over 1,000 ETH per day and about the same amount is the daily income of validators. Consequently, the income of the latter will double.
  
  
• In addition to "tips," validators will receive Maximum Extractable Value (MEV). Flashbots researcher Alex Obadia estimates that MEV revenue could increase their income by 75%.
  
  

Liquid Stacking and the Risks of Centralization

Staking-as-a-Service (SaaS) platforms account for an increasing share of the Beacon Chain. The undisputed leader in this segment is the liquid-stacking service Lido.


The chart below shows that major exchanges also have significant weight: Kraken, Binance and Huobi.

Data: Etherscan


The popularity of SaaS providers is largely due to the fact that such platforms greatly simplify and democratize shaking thanks to the possibility of delegation. Users do not need to possess 32 ETH - small amounts can be leveraged. No in-depth technical knowledge is required, either.

In addition, many SaaS providers offer users the ability to insure losses from slashing. Also, liquid stacking services help increase capital efficiency - for example, Lido issues derivative tokens that represent funds blocked in a staking contract. Such coins can be leveraged in DeFi-protocols to generate additional revenue.

"Given the higher yield of ETH derivatives over ETH itself, tokens like rETH and stETH may at some point become competitors and even surpass ether in the context of liquidity and acceptance as the primary currency for DeFi-operations," Galaxy Digital Research shared their thoughts.

The chart below shows that Lido is far ahead of the competition in its segment.

Dynamics of the volume of funds in popular stacking protocols. Data: Dune Analytics (@LidoAnalytical).


Bankless co-founder Ryan Sean Adams has suggested that over time ETH will become something like perpetual Internet bonds, whose holders will be both creditors and owners of the network. Thus, ether, as an underlying asset, will become less and less involved in dapps.


Given the wide range of interesting options from SaaS providers, we can expect further growth in their popularity and hence in the value of assets under management (TVL).


There is a trend towards decentralization in the segment. For example, Lido is introducing distributed validator technology. A newer service, Rocketpool, positioned as a decentralized steking platform, is gradually gaining momentum.


When will Merge be activated?

Testing of The Merge is in full swing: on June 8, Ethereum developers migrated the Ropsten network to PoS. Goerli and Sepoila testnets are expected to transition within weeks.


In May 2022, Preston Van Loon, one of the leading developers, said that the transition of mainnet to PoS will take place in August. Vitalik Buterin also named the last month of summer as the most likely date, but allowed the event to be moved to September-October if "potential risks" arise.


According to conservative scenarios from Messari, The Merge will activate in November-December.

Analysts expressed confidence that after the upgrade Ethereum will no longer be perceived as a "utopian experiment. On the contrary, the cryptocurrency will attract long-term investors.


Messari admitted that the staking fee will be in the range of 7%-13%.


Future Development

After the activation of The Merge, an important event will be the Shanghai hardforge. It is intended to increase the scalability of the network, make stacked funds available, and modernize the Ethereum Virtual Machine (EVM).


In March, Vitalik Buterin shared the idea of Proto-danksharding, a data validation scenario focused on transactions carrying so-called blocks that cannot be executed by EVMs.

Proto-danksharding is intended to replace danksharding, a sharding technique in which only one proposer selects all transactions and data falling into a particular slot. This approach was introduced in February 2022 by Ethereum Foundation researcher Dankrad Feist.


The Ethereum founder suggested automatically deleting large binary object data every Z0 days so that the network does not place too many demands on data and memory storage.


There is also EIP-4488, aimed at extending the use of Ethereum-based Rollups. This relatively simple solution was originally planned to be implemented before The Merge was activated. EIP-4488 reduces by a factor of five the cost of sending transaction packets from Layer 2 networks to the Ethereum blockchain.


"Although The Merge is the most complex upgrade in Ethereum history, it is not the last network upgrade," Galaxy Digital Research stressed.


After that, the researchers believe, developers will focus on other pressing, years-old issues like scalability and statelessness.


Galaxy Digital Research also predicted other consequences of Ethereum's move to PoS:

• The popularity of GPU-based cryptocurrency mining will decline. Some miners will switch to alternative coins like Ethereum Classic or Ravencoin. Many will simply sell video cards, which will then go to gamers and designers. This will lower the price of the devices on the market and affect the profits of the manufacturers.
  
  
• Bitcoin, which remains the largest PoW cryptocurrency, will be even more criticized for the high power consumption of the network.
  
  

Conclusions
According to optimistic predictions, The Merge is expected to be activated in August. However, given the technical complexity of the merger process and the propensity of developers to postpone upgrades, this event could also take place in the deep fall.


One of the most significant consequences of the move to PoS will be the attrition of miners from the game. This could significantly affect market conditions in the short term. Sales pressure is likely to decrease and hash rates of altcoins like Ethereum Classic will increase.


In the medium to long term, Ethereum could become a more investable cryptocurrency. First, the project will prove to be anti-fragile. Secondly, the asset will comply with the trend towards environmental friendliness.


Finally, deflation will definitely do its job. However, its level will depend on user activity.


The Merge is not the last important update of Ethereum. It will help to solve the problem of scaling, where the big role is given to sharding and Rollups.