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

By Rodrigo Zepeda, CEO, Storm-7 Consulting

Introduction

Part III of this Primer Series will seek to explain the importance of certain events that will occur after The Merge within the Ethereum ecosystem, and why these events are so important. These events include the concept of Ethereum ‘Triple Halving’, the proposed Ethereum ‘Shanghai’ upgrade, and the scheduled introduction of Ethereum ‘Sharding’ and ‘Shard Chains’. These events will show why The Merge should not be viewed in isolation, but rather as a milestone in the envisaged evolutionary timeline of the Ethereum ecosystem. They are important to understand from an Ethereum investor perspective as well. They are set out in detail here, as they will also form a crucial background to fully understanding the expected or likely short term and long term technological, financial, and business ramifications of The Merge, which will be covered in Part IV of this Primer Series. We will first touch upon the nature of Ethereum gas prices which form a fundamental part of the Ethereum network.

Ethereum gas prices

The term ‘gas’ in relation to the Ethereum network refers to a unit that measures the amount of computational effort that is required to execute specified transactions on the Ethereum network (Ethereum (gas)). Gas refers to the fee that is required to successfully carry out a transaction on the Ethereum network (it is denoted in ‘gigawei’ (GWEI), one-billionth of one Ether ‘ETH’) (Ethereum (gas)). Transactions include actions such as, moving ETH from an Ethereum wallet to another wallet, or running applications on the Ethereum network.

By requiring Ethereum network fees to be paid only in ETH, Ethereum automatically creates a market in the native cryptocurrency. In theory, the lower the gas fees required to carry out transactions on the Ethereum network, the more attractive the network will be to users and developers. Historically, between January 2021 and May 2022, the average gas fee amounted to around $40 (the highest average daily gas cost recorded during this period was $196.638 on 1 May 2022) (Sarkar 2022).

It has therefore been observed that it is the extremely high gas fees that have been attributed to the Ethereum network’s biggest roadblock to mainstream dominance (Sarkar 2022). If we compare typical interchange fees for consumer payment cards in the United Kingdom, these are around 0.2% for debit cards and 0.3% for credit cards. In practice, card payment networks would never have been able to gain scale if they were charging $40 per transaction. So, the reality is that Ethereum gas fees must be reduced somehow if the network is ever to achieve its true global potential in the future.

These high gas fees can significantly inhibit markets which are based on the Ethereum network, a prime example being the market for non-fungible tokens (NFTs), as in practice NFTs are typically charged extremely high Ethereum gas fees to mint and execute NFTs. At the same time, more complex transactions that involve smart contracts require additional gas fees to be paid (Nibley 2022). So, high gas fees may also be potentially significantly inhibiting the wider development of a diverse range of future smart contract applications. Lower gas fees in the future might significantly lower entry barriers for Ethereum smart contract application developers.

Ethereum ‘Triple Halving’

Following on from The Merge, the new Ethereum framework will undergo what has been referred to as ‘Triple Halving’ (Shamapant 2022). This can only occur if The Merge is successful, which is another reason why The Merge is such an important event within the evolutional trajectory of the Ethereum platform. The concept of ‘halving’ derives from the Bitcoin (BTC) ecosystem where a halving event (the Halvening) essentially results in BTC mining block rewards and the issuance of new BTC both being cut in half (Taveski 2022).

By creating BTC scarcity, this halving event enables the BTC ecosystem to periodically reduce the rate of inflation, and it is important to note that it has generally been accompanied by a significant increase in the BTC price, i.e., market supply and demand factors at play (Taveski 2022). For example, in May 2020 BTC halving resulted in decreased rewards from 12.5 BTC to 6.25 BTC, and six months later the BTC price had increased from $8,800 to more than double this price (Akintade 2022). With respect to the Ethereum network, Triple Halving is therefore a halving event of sorts, but it is much more potent as it will feature a mixture of three underlying components or driving factors, which are:

(1) reduced ETH issuance (a drop in net annual ETH issuance from between 4.3%-4.5% (around 15,000 ETH daily issuance) to between 0.3%-0.4% (around 1,500 ETH daily issuance) because of validators consuming less energy post-Merge;

(2) burning of ETH (a part of each Ethereum transaction fee is burnt resulting in a systemic reduction process leading to deflationary pressure within the Ethereum network); and

(3) staked ETH (under the new proof-of-stake (PoS) network ETH owners will stake tokens and obtain staking rewards (e.g., around 4% Annual Percentage Yield (APY) at present) (Akintade 2022; Crnogatic 2022; Mirza 2022).

The overall end result is, first, a dramatically reduced annual issuance of ETH which should potentially decease selling pressure and increase the price of ETH based on the function of supply and demand (Crnogatic 2022; Mirza 2022). Second, following on from the London hard fork update, base fee burning was introduced further to Ethereum Improvement Proposal (EIP) 1559 (Crnogatic 2022; Mirza 2022). A certain fraction of transaction fees will be burnt for every transaction undertaken on the Ethereum network leading to deflationary pressure.

Third, the whole Ethereum network will function under the new staked ETH PoS model (Ethereum Staking). Ethereum Staking refers to the act of depositing 32 ETH on the Ethereum network to activate validator software on the new PoS Ethereum network post-Merge (Ethereum (staking)). Those participating in Ethereum Staking will receive a range of ETH rewards in return for carrying out different actions as Ethereum validators. The anticipated staking rewards post-Merge are placed conservatively between a 5% to 7% reward rate (Dobos 2022). However, the reward rate is very difficult to predict accurately at present. Ethereum envisages that there will be four main ways of ETH staking under the new system, namely:

(1) solo home staking (individual stakes 32 ETH using a home computer and receives full staking rewards);

(2) staking as a service (individual stakes 32 ETH but delegates technical staking to a third-party);

(3) pooled staking (ETH stake pooling solutions provided by third parties which allow individuals to stake a fraction of the minimum 32 ETH requirement); and

(4) centralised exchanges (individuals utilise an ETH staking service provided by a centralised crypto exchange which may offer lower overall staking yields) (Ethereum (staking)).

In the present context, the main point to note about Ethereum Staking post-Merge is that all ETH owners who have staked their ETH will not immediately be able to withdraw their staked ETH, which will further reduce the amount of ETH in circulation (Akintade 2022). Withdrawal of staked ETH will only be able to take place once the Ethereum 'Shanghai' update has been implemented in 2023. In addition, ETH used in decentralised finance (DeFi) exchange lending platforms will add to the locked away supply of ETH (Shamapant 2022). In February 2022, there was approximately 8.8 million ETH locked in DeFi, however, as Ethereum gas fees decrease and Ethereum Layer 2 (L2) solutions increase in 2023, this figure is likely to significantly increase (Shamapant 2022). All of these factors will joinly contribute to the Triple Halving effect on the post-Merge Ethereum network.

Ethereum ‘Shanghai’ upgrade

We noted in Part II of this Primer Series that gas fees would not be immediately reduced following on from the implementation of The Merge in September 2022. This is because the network upgrades required to bring about a widescale reduction in gas fees will form part of the final Ethereum ‘Sharding’ upgrade scheduled for some time in 2023. The Ethereum ‘Shanghai’ upgrade is intended to implement an interim solution to the high gas fees problem. This upgrade is intended to be implemented a few months on from the final implementation of The Merge.

There are three main areas covered by the Shanghai upgrade, namely: (1) deployment of the Ethereum Virtual Machine (EVM) Object Format (to improve EVM functionality); (2) implementation of Beacon Chain withdrawals (to facilitate withdrawals of previously staked ETH); and (3) L2 fee reductions (Beiko 2022). L2 refers to a secondary protocol (framework) that is built on top of the Layer 1 (L1) blockchain protocol, i.e., the Ethereum main network (mainnet).

The Beacon Chain withdrawals are crucial because, given that The Merge facilitates a transition from a proof-of-work (PoW) protocol to a PoS protocol, any ETH staked by validators has to be able to be withdrawn from the Beacon Chain if the PoS model is to function effectively in the long term. In practice, it has been proposed L2 fee reductions may be addressed via the implementation of either a CALLDATA cost reduction on the mainnet, or implementation of ‘proto-sharding’ (a mini version of full Ethereum Sharding) (Beiko 2022).

Either way, these changes are intended to reduce gas fees until final implementation of Ethereum Sharding (Grullon 2022). The L2 fee reductions directly target what is referred to as ‘roll-up technology’ (roll-ups). Roll-ups are L2 technology solutions (e.g., Arbitrum, Optimism, Polygon, zkSync) that help transactions to be processed off-chain (Ethereumprice). If L2 roll-ups process transactions off-chain, they should be able to make significant savings on on-chain gas costs as a result, thereby potentially driving down gas costs paid by Ethereum end-users (Kessler and Young 2022).

Ethereum ‘Sharding’ and ‘Shard Chains’

The final phase for the transition to the Execution Layer is scheduled to occur sometime in 2023, and it will involve a transition to what are referred to as ‘Shard Chains’ (Millman, Graves, Kelly 2022). Technically, the term ‘sharding’ refers to the splitting of a database horizontally in order to spread the load (Ethereum (sharding)). Instead of the Ethereum blockchain being comprised of a single chain with consecutive blocks, the blockchain will be split up into 64 different Shard Chains, which will facilitate the handling of transactions via parallel chains, as opposed to consecutive chains (Millman, Graves, Kelly 2022).

By upgrading the Ethereum network in this way, Shard Chains will provide secure distribution of data storage requirements, and they will enable roll-ups to be even cheaper (L2 solutions can offer even lower transaction fees) (Ethereum (sharding)). In this way, Ethereum Sharding and the introduction of Shard Chains should massively advance network scalability whilst also facilitating more widespread development of L2 roll-ups (Crnogatic 2022).

Prior to The Merge, every single computer (node) operating on the Ethereum 1.0 PoW network needed to store all transactional data. By using Shard Chains, data in the new Ethereum 2.0 PoS network will be processed in parallel, and network validators will only be required to store a part of the blockchain, which should significantly reduce latency and transaction times (Crnogatic 2022). As was noted in Part II, the 30 transactions per second (TPS) limitation should be increased to 100,000 TPS instead (Millman, Graves, Kelly 2022).

In theory, this will make it much easier to run nodes, the speed of processing transactions will significantly increase (faster transaction finality), and network storage capacity should significantly increase. Because of this increased potential scalability within the network, increased network capacity should not automatically lead to increased competition and increased gas fees on the network. Instead, such PoS Shard Chain scaling combined with increased L2 roll-up solutions should lead to significant reductions in gas fees across-the-board.

This is precisely what is required in order for the Ethereum platform to be able to facilitate anticipated huge growth in decentralised applications (DApps) worldwide (Hertig 2022). In effect, in order for Ethereum to scale-up globally in a decentralised way, it needs to be able to store and process massive amounts (petabytes) of data along the same lines of centralised data services offered by global data providers such as Amazon Web Services (AWS) (Hertig 2022). Consequently, it is this Sharding upgrade that should ultimately lead to massively improved scalability, and vastly improved speeds of network operations in the final Consensus Layer (Ethereum 2.0).

We say in theory and should, because technically speaking, sharding has never been implemented in a blockchain before (Crnogatic 2022). So, by analogy to the film 'Top Gun: Maverick', The Merge represents 'Miracle 1' and Sharding and Shard Chains represent 'Miracle 2'. In all likelihood, even if Sharding and Shard Chains are implemented in the Ethereum network some time in 2023, there may still be operational problems to overcome, e.g., implementing secure communication methodologies between the Beacon Chain and the Shard Chains, addressing increased vulnerability to malicious attacks, addressing more complex code which increases vulnerabilities in smart contract security protocols (Crnogatic 2022; Hertig 2022).

To be continued.