The most widely used blockchain, Ethereum, is set to undergo a major upgrade to its protocol, from proof-of-work to proof-of-stake, sometime next month.
The upgrade will bring significant changes to the Ethereum network and potentially change the investment outlook for the popular blockchain.
For that reason, advisors should be prepared to educate their clients on the transition. This includes first educating them on what Ethereum is – including some of the basic plumbing behind the network – and then on how the transition could affect their current crypto holdings.
What is Ethereum?
As the largest cryptocurrency behind bitcoin (BTC), ether (ETH) has a current market cap of over $180 billion.
Ethereum is a decentralized blockchain powered by its native currency, ether. Ethereum is responsible for the creation of smart contracts, which power many of the most most important crypto initiatives, such as decentralized finance (DeFi), decentralized apps (dapps) and non-fungible tokens (NFT).
Ethereum is currently powered and secured by a proof-of-work (PoW) consensus mechanism, which incentives network participants to solve arbitrary mathematical puzzles. Under the current PoW system, Ethereum miners earn 2 ETH per block mined, which occurs approximately every 10-19 seconds.
What will the merge do?
The Ethereum Merge will shift the Ethereum security mechanism from proof-of-work to proof-of-stake (PoS) and greatly impact the tokenomics of the blockchain.
Proof-of-stake is a consensus mechanism (currently being used by many protocols such as Cardano), which is powered by users staking their coins in exchange for the ability to validate new transactions on the network. Once the requirements of the network are met by validators, a new block is created and participants are awarded native tokens for their assistance in securing the network.
Under the new PoS mechanism, Ethereum will be secured by validators instead of miners. These validators will create blocks when chosen by the blockchain and confirmed by others, in turn helping secure the network. When a new block is added to the network, rewards will be distributed in ETH in proportion to each validator’s stake.
Read more: What Is the Ethereum Merge?
Although it will require significant technical knowledge to run an Ethereum validator, it will be made accessible to many investors through staking in a pool or with the assistance of a third party. The network will require a validator to stake 32 ETH in order to participate in the validation mechanism.
Ethereum will be secured by validators “staking” their ether. While it only takes 32 ETH in order to be a network validator, the more ETH that is staked, the greater the chance of being selected by the network. When a validator is selected by the network, that staker will earn a reward generated through transaction fees.
The transaction fees paid to validators are the “gas fees” that users pay in order to transact on the blockchain. Part of the PoS transition will introduce sharding – a technical upgrade that splits the Ethereum network into different pieces in order to increase transaction speed and reduce network fees. The introduction of sharding is expected to lower costs and increase transaction speed.
How the merge will affect supply
Investors have long believed that the 21 million BTC supply cap of bitcoin is one of the strongest features of the most popular cryptocurrency, unlike any fiat currency in existence. Investors have often referred to bitcoin as “digital gold” and have allocated capital to bitcoin based on its tokenomics and supply transparency.
Ethereum is currently unlike bitcoin in this aspect. The current ether inflation rate has been steadily increasing since the launch of the project, a topic that many crypto enthusiasts have often pointed out as a negative feature of Ethereum.
Ethereum has historically had a much higher inflation rate than Bitcoin and no theoretical cap on total supply. With the planned upgrade, the fundamentals of Ethereum are likely to change.
The Ethereum upgrade will likely decrease the total ETH supply and provide token holders with an opportunity to stake their tokens. Because of the expected yield generated through staking, it is likely that the total market interest in Ethereum will increase as an investor can participate in income generation for holding their ETH.
A decrease in the total supply of ETH will likely be seen as a positive change to the second largest cryptocurrency.
Christine Kim, research analyst at Galaxy Digital said, “Supply should contract rather than expand over time. And so I think that’s a huge boost to Ethereum’s investment narrative as a store of value and as a hedge against inflation.”
In order to successfully mine on a PoW blockchain, an individual has to make a significant capital allocation. Running a PoW mining operation is cost intensive, often requiring the purchase of hardware, power-supply upgrades, and logistical solutions.
The transition from PoW to PoS will reduce the capital barrier needed to secure Ethereum, allowing many new market participants to stake their ETH and help secure the network.
The current cost to run an Ethereum node is approximately $36,000 USD (per current prices), allowing retail investors to pool their ether and profit from staking.
How the merge will affect energy efficiency
The Ethereum merge will increase the efficiency of the Ethereum network.
The PoS upgrade will dramatically decrease the energy requirements of the Ethereum blockchain and therefore the overall consumption by the network.
Those wishing to secure the network will no longer be required to run expensive and energy inefficient mining hardware and will instead be able to run a validator node.
Although PoW blockchains are highly secure from a network perspective, the PoW consensus mechanism requires miners to use tremendous amounts of energy. The amount of electricity required to secure the Bitcoin blockchain has a comparable carbon footprint to many small nation-states, according to ConsenSys, a blockchain software company founded by Ethereum co-founder Joseph Lubin.
Many environmentally friendly investors have spoken out against the energy consumption of PoW blockchains. With ESG investing growing in popularity, many investors are simply not allowed to invest into projects that have a negative effect on the environment or climate. PoS blockchains are significantly more efficient and require a small fraction of the energy used to secure PoW blockchains. The merge will allow an investment into ether to be seen more favorably by those investing with strict environmental requirements.
Many investors, including large institutional investment firms such as endowments, family offices, and pension funds, are extremely interested in cryptocurrency investments. They are governed by environmentally conscious investment standards (ESG) and have expressed concern with the energy requirements of PoW networks. While PoW networks are secure, the Ethereum upgrade to PoS will likely satisfy the strict ESG requirement and allow new entrants into the market.
Use case benefits of the merge
The Merge will have many significant implications on the crypto market. Ethereum’s transition from PoW to PoS will prove that a decentralized and permissionless network can operate in an energy-efficient manner. Successful transition to PoW will likely cause a renewed interest in Web3 projects aiming to build on top of the Ethereum network.
Looking at the macro picture of crypto markets, we are currently seeing tremendous interest in Web3. Non-fungible tokens (NFT), decentralized finance (DeFi) and decentralized apps (dapps) are growing significantly, despite the overall bear market in crypto prices. Venture investment into Web3 has been accelerating, with many developers continuing to enter the blockchain space.
There are two main concerns stalling Web3’s development: (1) energy-efficient blockchains that are secure and decentralized enough to build upon and (2) recruiting talent and developers to the space to help build these ambitious projects.
In other words, the current Ethereum blockchain is unable to handle additional high-volume projects due to the high transaction fees and environmental concerns the current PoW mechanism limits.
The Ethereum upgrade will likely address these concerns in a way PoW networks have been unable to, allowing many Web3 companies to build their projects on an incredibly efficient and secure network. The increased efficiency of the network will provide a solid and efficient foundation to build upon.
The merge will improve nearly all metrics of the Ethereum blockchain, paving the way for future innovation of applications and experimentation. Ethereum’s smart-contract capabilities have been used to create thousands of dapps, have attracted millions of users, and have generated billions of dollars for investors and users.
Because of the capabilities of Ethereum, we have seen the creation of many significant projects including:
- Decentralized autonomous organizations (DAO)
- Decentralized finance (DeFi)
- Initial coin offerings (ICO)
- Security token offerings (STO)
- Non-fungible tokens (NFT)
How investors can prepare
Ethereum’s transition to a PoS mechanism will increase diversification of Ethereum, change its tokenomics and decrease its energy requirements.
When comparing the tokenomics of ether to those of bitcoin, it is important to note that the Ethereum upgrade is still not entirely confirmed. The upgrade has been planned for years and further delays are certainly possible.
Investors need to understand that this upgrade is incredibly complex and it is likely to be delayed and there are possible issues that may arise. Announcements of further delays could not only negatively affect the price of ether but could affect bitcoin and other cryptos as well.
Bitcoin, by comparison, is incredibly transparent and is the most secure blockchain in existence. Investors preferring less volatility ahead of the upgrade may find Bitcoin a safer bet.
Whether or not investors stand to benefit by positioning themselves in ETH ahead of the upgrade will depend on a variety of factors, especially the overall market climate. Advisors should be prepared to educate investors on these risks.
However, assuming a successful upgrade on Ethereum, investors will need to look at an investment into Ethereum through a different lens than they have historically, as many features will have changed significantly.
Ethereum is currently the second-largest cryptocurrency by market cap, behind only bitcoin, and is currently the biggest and most established smart-contract enabled cryptocurrency. Ethereum has many competitor blockchains, such as Solana and Cardano. These programmable smart contract networks have already adopted the PoS mechanism and are aiming to attract new users, many of whom have migrated away from Ethereum.
The Merge will position Ethereum in direct competition with these other layer 1 networks while also allowing for a robust layer 2, or companion, ecosystem to be built on top of the network. While the upgrade has been delayed multiple times, successful implementation will ensure that Ethereum remains the leading smart-contract network and position it for future growth.