If you have been on Crypto Twitter at all this summer, then I am sure you are well aware that it's finally here. The long-awaited event known as “The Merge” has an anticipated date of mid-September. If you are not sure of what that means, the quick summary is that Ethereum is changing from a Proof of Work consensus mechanism to a Proof of Stake consensus mechanism. We will dive into the implications of this change and reasons behind Ethereum making the switch, but before we do that, we should take a step back and understand what exactly a blockchain is, why coming to consensus is important, and how the two main consensus mechanisms differ from each other.
A blockchain is a public, decentralized database used for all cryptocurrency transactions. Every time you make a purchase with a cryptocurrency, the transaction is recorded “on-chain” and made available to the public. The information about the transaction gets stored in a “block” and then added as the next block of information in the link of blocks, known as the “blockchain.” Each block contains the time of purchase, purchase amount and the two parties involved in the transaction. The transaction can be traced by a transaction “hash,” a unique identifier made of numbers and letters that is generated every time a transaction is made on-chain.
The hash cannot be altered once the transaction has been completed and sent to the blockchain. As more and more people make crypto transactions, blocks get finalized and the height of the blockchain grows. Every transaction must be verified before it gets added to the blockchain. Once a transaction is made, the applicable consensus mechanisms (such as “Proof of Work” or “Proof of Stake”) confirm that the transaction is legitimate and does not already exist in the system. These consensus mechanisms facilitate social trust and help ensure that no payment is charged more than once. However, such consensus protocols can delay the transaction time because they require sophisticated computational power to achieve consensus.
Consensus Mechanisms
There are two main consensus mechanisms currently used in blockchain, Proof of Work and Proof of Stake. There are actually quite a few other consensus mechanisms being experimented with, but these are the main two and for the purposes of this article, we will focus on these because Ethereum is moving from Proof of Work to Proof of Stake in an event famously heralded as The Merge.
Proof of Work
Proof of Work was introduced alongside Bitcoin by the legendary Satoshi Nakamoto in the Bitcoin white paper in 2008. Proof of Work is used as a protocol for generating new blocks while maintaining the network through the mining process. In exchange for rewards, miners need to maintain the network by solving intricate cryptographic problems called proofs. The implementation of Proof of Work aims to decentralize transactions and to eradicate the possibility 51% which would allow the attacker to double spend.
There are at least a few problems with Proof of Work:
High energy use: Currently, Bitcoin uses as much energy as many smaller developed countries because of the energy needed to run the mining machinery needed for Proof of Work. And its energy use is increasing as more miners join the network, though many of the miners claim that their operations are powered by renewable energy.
Mining centralization: Proof-of-work is all about creating a currency without one single entity in charge. That said, in practice the system is somewhat centralized, with just three mining pools controlling almost 50% of Bitcoin's computational power.
51% attacks: If one mining entity is able to accumulate 51% of Bitcoin's mining hashrate, it can then break the rules temporarily, double-spending coins and blocking transactions.
Proof of Stake
Proof of Stake blockchains use nodes in the network running a particular software to validate blocks, rather than allocating their computing resources to “mine” them. A proof-of-stake network functions as a cryptographic proof of ownership and proof of vested interest in the project’s ongoing success. Within these networks, security and consensus is achieved by participants committing, or staking, their capital in the form of the network’s native tokens in a node. To participate in maintaining the network, nodes “lock-up” native tokens using a smart contract, rendering them unspendable for the allocated time. To extend the consensus history on the blockchain, a deterministic algorithm randomly selects which nodes become validators for each new block. Hence, in Proof of Stake consensus networks, the role of proving the validity of the transactions falls on the validators, not miners.
In Proof of Work, miners prove they have capital at risk by expending energy. In Proof of Stake, validators explicitly stake capital in the form of the blockchains native token, in Ethereum’s case, Ether, into a smart contract on Ethereum. This staked Ether then acts as collateral that can be destroyed (or “slashed”) if the validator behaves dishonestly or lazily. The validator is then responsible for checking that new blocks propagated over the network are valid and occasionally creating and propagating new blocks themselves.
Ethereum making the shift to Proof of Stake comes with some key improvements over the current Proof of Work system:
Accessibility: The barriers to entry to becoming a Proof of Work miner are high. A miner must purchase, set up, and maintain all the necessary hardware to run a Proof of Work mining rig. Additionally, Proof of Work mining requires a substantial amount of energy to maintain. Not only is the underlying mechanism inefficient from an energy standpoint, but it further increases the barrier to entry. To earn significant block rewards, it is better for a miner to live in a region with lower electricity costs. Additionally, jurisdictions often offer lower electricity costs to corporations, meaning a miner who wishes to maximize their profits would need to form a company and purchase enough mining hardware to offset the effort and associated costs. Altogether, energy inefficiency, variable electricity costs, hardware costs, and corporate electricity breaks all present significant barriers to entry for most would-be miners.
Centralization: Barriers to entry for mining can have the adverse secondary effect of greater centralization of miners. As it gets more costly and less profitable to become a miner, the network naturally sees a concentration of mining into two categories. First, large mining conglomerates that operate in areas with low electricity costs and cold weather (to reduce the cost of manually cooling mining hardware) such as Mongolia and Siberia. Second, mining power is centralized in the hands of mining pools. As it becomes less profitable for most people to mine individually, they buy hash power from a mining pool, which operates as a single mining entity. As of July 24, 2022 the date of writing this, over 53% of the hash power is controlled by the top 3 mining pools, and 74% when you include the top 5 pools.
Scalability: In the current Ethereum Proof of Work chain, each block is mined consecutively. Each block can only contain a certain amount of data, known as the block size. This means that if there are more pending transactions than can fit into a block, the transactions that do not make it into the next block to be mined must “wait” for the following block for another chance to be included. On Ethereum, a block is mined once every ~13/14 seconds, but during particularly high transaction events, some users could wait hours for their transactions to be processed. The switch to Proof of Stake shortens block times to 12 seconds, which allows for a 10% increase in throughput. The switch also sets the stage for other scalability implementations, such as sharding.
Issuance: Because of the low energy requirement, less ETH issuance is required to incentivize participation. At the time of writing, approximately 13,500 ETH is issued daily to validators and miners. After the Merge issuance will drop to approximately 1000 ETH per day, and in conjunction with the burn mechanics implemented in EIP 1559 which burned 73,820 in the last month according to watchtheburn.com, or approx. 2500 ETH per day, leads to ETH becoming a deflationary asset. This is being referred to as the Triple Halvening as the reduction will be equivalent to nearly three bitcoin halvenings in one event.
UPDATE 8/19/22: Its estimated that Ethereum would need to average 15 gwei or higher in order to burn enough Ether to become a deflationary asset. Currently, the average gwei is below 15 gwei, so ETH would not be quite deflationary post-merge unless this occurs.
Penalties for Bad Actors: Economic penalties for misbehavior make 51% style attacks exponentially more costly for an attacker compared to proof of work. The community can resort to social recovery of an honest chain if a 51% attack were to overcome the crypto-economic defenses. After The Merge, it will cost approximately $15 Billion to attack the Ethereum network. Because of the mechanisms in place, the attacker risks losing their entire stake to slashing for trying to act in an improper manner.
This brings us back to the first step on the updated Ethereum Roadmap and self proclaimed “Most significant upgrade in the history of Ethereum” according to the Ethereum Foundation, The Merge.
Today, Ethereum Mainnet continues to be secured by Proof of Work, while the Beacon Chain runs in parallel using Proof of Stake. The approaching Merge is when these two systems finally come together, and Proof of Work is replaced permanently by Proof of Stake. The Merge represents the formal adoption of the Beacon Chain as the new consensus layer to the current Mainnet execution layer. Once The Merge happens, validators will be assigned to secure Ethereum Mainnet, and mining on the Proof of Work chain will no longer be a valid means of block production. Blocks will instead be proposed by validating nodes that have Ether staked for the right to participate in consensus. As we mentioned previously, it eliminates the need for energy-intensive mining and instead secures the network using staked ETH, resulting in a 10,000x reduction in Ethereum’s power usage. Currently, Ethereum can use anywhere from 0.1-0.3% of all energy used on a given day globally according to Justin Drake on the Defiant Podcast. This switch drastically reduces Ethereum’s footprint.
In the words of Ethereum Foundation engineer Justin Drake, in order to prepare for The Merge, the Beacon Chain and the Paris Chain (the chain that runs the EVM) need to be hard forked so that they become aware of each other and point towards each other. Once this happens, and we reach the proposed date for The Merge, Proof of Stake will be the mechanism fully securing the Ethereum network, and the difficulty bomb will be introduced to the Proof of Work chain. The difficulty bomb is an update built into the protocol that will significantly increase the complexity of Proof of Work calculations, and therefore, the time required to process transactions, which will act as a kind of self-destruct mechanism meant to incentivize the transition to Proof of Stake for anyone trying to remain on the Proof of Work network and keep it going.
In summary, The Merge represents the new frontier for the Ethereum ecosystem. With newer layer 1 blockchains like Solana, Near, and Avalanche trying to take Ethereum’s market share, the pressure to solve the scalability issues Ethereum is facing puts pressure on the Ethereum ecosystem and its network of developers. That being said, pressure is often a necessary catalyst for progress, and a little healthy competition never hurt anyone. Although Ethereum currently has a network effect and a vast community on its side, it needs to address these problems to retain them. The Merge is the first step in the road map to making Ethereum the scalable network it needs to become in order to support what the entire community hopes will be trillions of dollars of decentralized economic value over time.
Not financial, legal or tax advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. All opinions expressed are solely those of the individual author. This newsletter is not legal advice and does not create an attorney-client relationship. This newsletter does not constitute tax advice. Talk to your independent attorney and/or accountant for any questions specific to you. Always do your own research and use caution when interacting with smart contracts or the blockchain.