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June 25, 2024
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Ethereum Merge – What Changed and What's Next?

Ethereum Merge – What Changed and What's Next?
Summary

In September 2022, Ethereum achieved an impressive feat, becoming the first major blockchain to change its consensus model mid-flight. Without any downtime or noticeable impact on the thousands of applications running on the network, Ethereum network participants moved from mining blocks using the energy-intensive proof-of-work consensus to validating blocks under the far greener proof-of-stake model. This shift has resulted in several important changes to how Ethereum operates and the economics of the ETH currency.

Our article provides a comprehensive overview of the changes resulting from the Ethereum Merge and outlines what comes next for the original smart contract platform.

What changed with the Merge? 

Ether Issuance

One of the most important implications of the Merge is a change to the way that new ether is issued. When Ethereum launched in 2015, it used proof-of-work consensus. Each miner received a reward of five ether (ETH) per block in addition to the associated fees for each transaction within it. Block rewards decreased to three ETH per block following the Byzantium hard fork in October 2017, and to two ETH after the Constantinople hard fork in 2018. In July 2021, the London hard fork introduced a mechanism whereby transaction fees are burned, with the intention of making ETH a deflationary asset over time.

As such, by the time of the Merge, miners were earning two ETH in block rewards plus any “priority tips” paid by users in addition to their transaction fees. Priority tips allow a user to make a discretionary payment to the miner as an incentive to prioritize their transaction for inclusion in a block.

Following the Merge, the reward structure has changed. Miners have been replaced by validators under the new proof-of-stake consensus model, and the issuance of new ETH has dropped dramatically. The new model is designed to introduce equilibrium between inflation and deflation.

There are now three main types of incentives:

  • Consensus Rewards
  • Execution Rewards
  • MEV (Maximal Extractable Value)

Consensus Rewards are earned by a validator for performing tasks such as attesting, synchronizing committees, flagging bad actors and, of course, proposing blocks. The more validators there are, the less likely they are to be chosen to carry out network tasks.

Execution Rewards are simply priority tips by another name. Each Ethereum user can opt to pay a priority tip for their transaction to be included in the block, with the tip paid to the block validator.

The last source of revenue is MEV, or Maximal Extractable Value, which represents the maximum value a validator can extract by deleting, adding and reordering transactions within a block.

The yield of the consensus layer is relatively flat at around 4%. However, MEV offers a way for validators to increase the yield of the execution layer.

Prior to the Merge, MEV was extracted by miners by selecting the most profitable transactions to include in a block. Following the Merge, validators must run an MEV-Boost client alongside their consensus client, which allows them to access a competitive market of blocks produced by block builders. Block Builder assembles transactions into blocks in such a way as to maximize MEV and submit them to the Block Proposer (with a bid) using a Relay. Block Proposers submit the block and received the bid.

The net result of these changes is that issuance of new ether is greatly reduced. Before the merge, mining rewards totalled around 13,000 ETH per day. After the merge, the staking rewards are only around 1,600 ETH per day. This is a reduction of almost 88% of minted ether.

In addition, following the precedent set by the London hard fork, some of the fees paid may now be burned. At times when network congestion is high, the base fee for transacting on Ethereum will rise, and more ETH will be burned. Once the rate of burning exceeds the rate of issuance, ETH becomes a deflationary currency. On the other hand, during low congestion, the base fee will fall, and therefore less ETH will be burned. If the issuance rate exceeds the burn rate, ether becomes inflationary.

Data source: https://ultrasound.money/

Block time 

Following the Merge, the block time has also changed. Before the Merge, block time was a factor of the Ethereum hashrate, meaning it was not possible to predict the exact time that would elapse between each block. After the Merge, Ethereum block production is timed based on epochs. An epoch comprises 32 slots, or blocks, that are separated by 12 seconds. Therefore, an epoch lasts 6.4 minutes.

Finalization also operates differently post-Merge. Block finality refers to the likelihood that a block can be changed as a result of rolling back the blockchain. Under proof-of-work, finality is probabilistic, meaning that the more subsequent blocks are mined, the lower the chances of a transaction being reversed. Under proof-of-stake, finalization is more explicitly defined. For an epoch to be finalized, at least 66% of the validators must agree on the previous two consecutive epochs. If the participation falls below 66%, the epoch cannot be finalized.

The consequence of these changes is that the time between each block is precise, predictable, and shorter than when Ethereum operated under proof-of-work.

Data source: Etherscan.io

This move to one block every twelve seconds has increased the transaction capacity of the network. However, the impact on fees is very minimal.

Energy consumption

Following Ethereum's change of consensus mechanism from proof-of-work to proof-of-stake, validators no longer need to run mining rigs to participate in the network. A computer with an internet connection and storage space is sufficient.

According to a CCRI report commissioned by ConsenSys, the Ethereum network's energy consumption decreased by more than 99.988% after the merger, from nearly 23 million megawatt hours per year to just over 2,600. As a result, CO2 emissions dropped from over 11 million tons per year to less than 870, which is equivalent to less than the annual energy consumption of a hundred homes in the US. The carbon footprint of blockchain and crypto-currencies are being increasingly discussed, especially the carbon footprint of Proof of Work blockchains. This transition opens the door to mass adoption of Ethereum-based applications and tokens by groups that would otherwise have been deterred by the high carbon footprint.

Having previously been heavily criticized for its high energy consumption, Ethereum is now much more viable for ESG investing, which has grown in popularity among both retail investors and financial institutions in recent years. In fact, according to a Bloomberg report on ESG investing, ESG-related assets are now accounting for one in three dollars managed globally, with assets under management by ESG funds set to reach $41 trillion by the end of 2022. This ESG investing by institutional funds could result in Ethereum and other energy-efficient crypto assets receiving large inflows of institutional capital.

Impact on decentralization

Staking decentralization

One of the criticisms leveled at Ethereum after its transition to proof-of-stake is the risk of centralization, and thus network security. There are fears that proof-of-stake could result in the aggregation of staked ETH to a small number of large players, who could effectively take control of the network.

Currently, the distribution of staked ether is as follows: Lido, which performs liquid staking, accounts for 27% of all the ether that secures the network, followed by an unknown group most likely comprising individual stakers with 26%, Coinbase 12%, Kraken 7% and Binance with 6%. The largest staking entities – Lido, Coinbase, and Kraken – account for more than 50% of all staked ether. However, Lido does not manage validator nodes, delegating this activity to more than thirty companies such as Blockfish, Figment and Blockscape.

Source : https://beaconcha.in/pools

In reality, proof-of-work consensus is arguably also subject to similar centralization risks due to the prevalence of mining pools. Furthermore, as mining has become more competitive, the barriers to entry have become higher since only those who can procure and maintain the latest mining equipment can participate. This is evidenced by the fact that currently, four mining pools control account for around 75% of mined Bitcoin.

Client diversity

Another way to measure the decentralization of a network is the diversity of clients. A client is a piece of software that controls the behavior of an Ethereum node. There are consensus clients and execution clients and both must be run to operate a node. 

For both types, there are several clients developed and maintained independently by different teams. This diversity makes the network more resistant to attacks and bugs. In the event of there being only one client and a hacker finding a bug in the code, the whole blockchain would be at risk. Currently there are five consensus clients and four execution clients. However, there is a somewhat uneven distribution across clients; therefore, the community is encouraging node operators to switch to less-used clients by publishing guides to migrate from one client to another.

Data source: https://clientdiversity.org/

MEV and OFAC Compliance

We mentioned this earlier. The relays send blocks to the block proposer. But some relays don’t include OFAC sanctioned transactions. For example, Flashbot is compliant and doesn't include transactions from blacklisted wallets. The percentage of blocks relayed by MEV boost is 91% with Flashbots ultra-domination accounting for 77% of its blocks. It is important to note that it is not the validators who censor because they are often connected to several relays. They use blocks relayed by Fashbots because they are the highest bidders, not because they necessarily want to censor.

Data source: https://mevboost.pics/

Ethereum Staking

There are various ways to participate in Ethereum staking. This started on 1 December 2020 with the launch of the beacon chain. Each person could register as a validator and deposit 32 ETH on a smart contract (https://etherscan.io/address/0x00000000219ab540356cbb839cbe05303d7705fa).

Since then, there are several ways to participate in securing ethereum and validating blocks.

The most profitable way is also the most technically complicated – by running your own validator node with a consensus client and an execution client. Becoming a validator also requires a minimum stake of 32 ETH. However, it is important to note that currently, it is not possible to unstake and withdraw the 32 ETH until the next Ethereum hard fork takes place, which is anticipated in 2023.

Another possibility for those who hold the minimum 32 ETH is to engage a trusted third party to set up and maintain the node.

A third route is to stake via a staking pool. This can be done in two ways – either via a staking pool operator or via a centralized exchange. Liquid Staking Derivatives (LSD) are a type of staking pool that emerged as a novel workaround to the problem of staked ether being inaccessible. They allow users to deposit ETH in an app for staking, and in return the user receives tokens as a representation of the staked ETH. The best known are Lido and its stETH token, Rocket Pool and its rETH and finally Coinbase and its cbETH.

LSD apps allow anyone to deposit ETH in a decentralized way and receive a share of staking rewards, while the staked ETH tokens can be used in DeFi applications, meaning the stake is effectively liquid.

However, the peg between ETH and stETH or other LSD tokens may not always be guaranteed to hold. The value of LSDs varies according to supply and demand. As an example, before the Merge, 1 stETH was traded at 0.94 ETH because there was a fear that the Merge may fail. However, following the success of the Merge, we can see that the peg (1LSD = 1ETH) was quickly reestablished (the last depeg was due to FTX's collapse).

Data source: Dune Analytics

Many of the largest centralized exchanges also offer staking pools, where they operate their own nodes and stake funds on behalf of users. This method is the most flexible and convenient, but it is often criticized because it could promote centralization. It is also the least profitable method because the company invariably takes a commission from the staking rewards distributed to users.

Next steps for Ethereum

Future updates and what this means for the network

The future of Ethereum can be broken down into six parallel phases:

  • THE MERGE : merge is done but there are still improvements to be made to make Ethereum robust and decentralised.
  • THE SURGE: increasing the scalability of the blockchain with multiple updates, including Proto-Danksharding (EIP-4844) which will create a new kind of transaction type to Ethereum.
  • THE SCOURGE : ensure reliable transaction inclusion.
  • and avoid centralization and other protocol risks from MEV.
  • THE VERGE: making block validation easier and more seamless.
  • THE PURGE: reducing the amount of storage space needed to store the Ethereum blockchain history on a hard drive.
  • THE SPLURGE: a generic category that broadly encompasses “everything else.”

These six steps are being developed simultaneously.

However, before they get underway, the Shanghai hard fork is the next major upgrade, which will finally enable staking withdrawals. It will also aim to reduce transaction fees on layer-2 platforms operating on Ethereum. Ultimately, Ethereum’s goal is to become a consensus and security layer supporting layer-2 platforms, such as Optimism or Arbitrum on which applications run. The Merge and subsequent Shanghai upgrade paves the way for new types of layer-2 platform which can harness cutting-edge innovations such as zero-knowledge rollups to achieve scalability.

The Merge may be the biggest change ever undertaken on a blockchain, but Ethereum’s journey of improvement is only just getting started.

Author
Nuant
Updated on
June 25, 2024