Overview

Earlier this month, Ethereum's Sepolia testnet was successfully merged, inching the Ethereum Mainnet one step closer to the actual "Merge." Goerli remains the only testnet left before the actual merge later this year. Goerli is planned to merge on August 11. Should that go well, the actual merge could take place in mid-September.

Tweet previewing The Merge debut around September 19.

There is no official roadmap for Ethereum, as it is predicated more on rough community consensus. However, a high-level, noncontroversial plan stretching into 2022-23 is generally regarded as the agreed-upon path for the project. Vitalik Buterin updated a more technical roadmap with each step's progress in December 2021. Specific developments are tied to future upgrades and are always subject to change.

"The Merge" is the next step, set to be completed in Q2 2022 and will remove PoW entirely in a network hard fork. The PoW Ethereum layer 1 execution layer will be "merged" with the Beacon Chain, allowing all execution to take place on the staking chain and making miners obsolete. However, redundancies and network inefficiencies will remain post-merge, eventually needing to be addressed. A "clean up" period will be required, but it will also enable highly-anticipated functionalities like the ability for withdrawals and transfers of staked ETH from the Beacon Chain.

Unofficial Ethereum roadmap (with progress bars) spanning into 2023. Source: Vitalik Buterin/Twitter

Scaling the Ethereum Network

On-chain scaling techniques upgrade a blockchain's base layer to improve scalability. Ethereum's long-term, on-chain scaling solution is sharding, which splits the base layer into 64 chains with shared security ensured by the Beacon Chain.

Off-chain scaling refers to scaling solutions that use external execution layers rather than the base layer. These Layer 2s or "L2s" are secondary layers that sit on top of the base layer, providing more transactional capacity for the blockchain overall. Ethereum is pursuing both off-chain and on-chain scaling strategies.

Ethereum's eventual transition to Proof of Stake responds to these challenges. It's a massive upgrade to the entire Ethereum ecosystem to accommodate continued growth and an increasing workload, consume less electric power in its verification process, and be more secure from attacks. The Ethereum upgrade will make the network more scalable, sustainable and secure.

Any human enterprise which is highly successful early on will quickly have to address how to do more to keep up with demand. This is a good problem to have but not an easy one to solve because scaling up often challenges the core values that made the enterprise successful.

Ethereum, as we know it today, won't scale to meet the needs of the entire globe. The Ethereum L1 is designed to remain a highly decentralized, global settlement layer above all else. However, Ethereum's web of L2s will be responsible for scaling Ethereum and serving as its execution layer. These layers will absorb much of the existing value on the Ethereum Mainnet plus future inflows as Ethereum adoption grows. It's important to understand that Ethereum's web of L2s is a marketplace of independent projects competing with each other to help scale Ethereum.

Transitioning from PoW to PoS ("The Merge")

The Merge is the term used for when Ethereum switches from proof-of-work (PoW) to a proof-of-stake (PoS) blockchain. It is a hard fork that moves consensus from the current PoW chain to the PoS "Beacon Chain." Blocks are "proposed" to the network by a distributed community of "validators," If enough validators come to the consensus that a given block is valid – meaning it contains only legitimate transactions – that block is added to the chain, and the process repeats.

The staking model has no advantage in having more computational or electric power because validators are chosen randomly. Therefore, Proof of Stake eliminates the proof-of-work arms race for more electricity and computing power.

But what compels a Proof of Stake validator to do their job correctly? If a chosen validator erroneously confirms a transaction or colludes with other validators to confirm transactions falsely, their staked ETH will be taken ("slashed") and their validator reputation tarnished. If a validator confirms transactions correctly (along with other validators until a consensus threshold is reached), they are rewarded with more ETH. Good behavior is rewarded, and bad behavior is decisively punished.

However, punishments (i.e., slashing) are not linear. Rather, they are executed via Quadratic penalties meaning a single validator going offline doesn't get penalized very badly. In contrast, a thousand validators doing it at the same time get penalized much more heavily.

This approach was implemented with the idea of encouraging decentralization. An ETH whale with thousands of validators is incentivized to spread them across different clients and avoid using cloud hosting services.

This is slated to occur in mid-September 2022, assuming the next Goerli testnet merge goes well!

Image showing the timeline of the Goerli testnet merge. — Updated roadmap to Ethereum Mainnet 2.0. Source: CoinGecko Quarterly Report Q2 2022

PoS removes the energy consumption often cited in the mainstream media. While PoW is not inherently bad, it's inarguable that the world is highly critical of energy consumption. With the transition to PoS, Ethereum will have eliminated this enormous criticism. Estimates from Ethereum core developers hypothesize that Ethereum's energy use will drop by up to ~99%. Without the need for so much physical mining hardware and infrastructure, Ethereum can become a more energy-efficient, geographically-distributed, and nimble blockchain.

An image showing Ethereum energy consumption. — Energy consumption of the largest cryptocurrency projects. Source: arXiv

Overall, Ethereum can remain just as secure but with a lower overall "energy budget" because less energy is required to achieve consensus. In PoS, stakers deposit capital rather than building giant mining farms. While a dramatic oversimplification, both approaches risk capital, PoS is more straightforward.

Ethereum's eventual transition from Proof of Work (PoW) to Proof of Stake (PoS) will represent the culmination of the original Ethereum protocol design, 5+ years of technical research and associated game theory design. It is ultimately designed for a more straightforward, robust, stable, and secure base layer protocol with complete lite client verifiability. PoS enables future improvements like light client, data sharding, statelessness, and more. After the implementation is complete, the base layer can then "ossify" while leaving the flexibility for innovation on higher protocol levels like layer 2.

The Beacon Chain serves as the epicenter of future architecture and network consensus. PoS aims to lower the cost of participating in securing the network by allowing anyone with ETH to stake rather than needing a giant million-dollar mining farm, as is the case in most PoW networks.

An image illustrating the Beacon Chain, active since 2020. — Illustrating Ethereum's Beacon Chain, active since 2020, merging. Source: CryptoPragmatist

With PoS, the Ethereum base layer will be managed by validators rather than PoW miners. A validator is a person or entity who locks up (stakes) 32 ETH to run a validating node and secure the Ethereum blockchain. This means that rather than relying on energy/electricity for security, as in PoW, Ethereum security will rely upon capital instead. With PoS and staking rewards, ETH becomes a productive capital asset with yield as well as the money underpinning network transactions and executing smart contracts.

The PoS upgrade will reduce Ethereum's inflation rate from ~4.5% to near zero. As of Q3 2022, the Ethereum protocol pays miners 2 ETH per block or ~13.5k ETH per day. Post-merge, the daily ETH issuance becomes variable based on the number of stakers. For example, if there are ~15 million stakers, the protocol will issue ~1,750 ETH daily. This amounts to a ~90% reduction in issuance, i.e., token holder dilution/sell pressure.

Thanks to the implementation of EIP-1559 and its fee-burning mechanism in mid-2021, Ethereum's net issuance is expedited to become deflationary once The Merge is released. EIP-1559 changed Ethereum's fee structure where transaction fees now have a base fee and a tip. The base fee is set by the protocol and adjusts every block based on network activity. The base fee no longer goes to miners but is instead burned. The tip is set by the market (can be zero in times of little congestion) and will go to the miners.

Summary

While the motivation for The Merge has many reasons, the results post-merge are similar to a Bitcoin halving. In fact, it's equivalent to THREE Bitcoin halvings! This is because:

Post-merge, Ethereum will become a PoS network which means it needs to issue less ETH per day to secure the network. Currently, every day ~13,200 ETH is minted by miners and ~1,590 ETH to stakers on the PoS chain. This combination (~14,790 ETH daily) corresponds to a 4.5% annual issuance rate. Post-merge, tt no longer needs to issue millions of ETH per year to miners to secure the network. This aspect takes ETH's to ~1%!
EIP-1559 burns part of Ethereum transaction fees, removing that ETH from circulation. Based on past Ethereum usage data, the amount of ETH that will be burned will outpace the modest inflation rate, making ETH deflationary.
Post-merge, the rewards for staking on the Ethereum beacon chain are projected to increase to ~10%+. This is an insanely attractive yield on one of the most conservative crypto plays in the industry. It will almost certainly attract millions of more ETH to be staked and thus removed from circulation. There is already 13M+ staked, with many projecting 30M over the coming years.
Post-merge, for ~6-9 months, selling pressure will be severely curbed. Staked ETH and block rewards cannot be sold/withdrawn until another hard fork (Shanghai) is released.

So… less ETH issued. More ETH burned. More ETH locked up. Less ETH selling pressure. This is a supply crunch that would make BTC halvings blush!

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