Analysis on The Merge: a look at economic & technical impacts post-merge

By TheOasians | The Oasians | 27 May 2022



In what is probably the most anticipated/controversial/debated topic in crypto — Wen Merge?

I’m not here to predict when the merge will happen or debate with haters on if it will happen at all (hint: obviously, I def think it will).

The focal point of this analysis is on the economic and technical impacts that will happen post-merge. If you only care about dwelling on when exactly The Merge will happen and nothing else, this is not the piece for you.

The emphasis of my research & analysis will be to answer the following questions:
1. What changes will be made to Ethereum?
2. What will the post-merge Ethereum chain look like to retail users or dApps?
3. How will The Merge affect EVM-compatible chains?
4. What are the estimated short-term/long-term performance of ETH post-merge?

Just a quick disclaimer, my research & analysis is never financial advice.

h/t to Tim Beiko from AllCoreDevs and a handful of devs (who wish to remain anonymous) for answering all of my technical questions and providing clarifications.

TL;DR

What is the Ethereum Merge?
The merge of current execution layer (PoW) and the Beacon chain (PoS consensus layer).

What can be expected of the Ethereum Merge?
Gas fees and scalability issues won’t be significantly addressed, only a shift in consensus mechanism. There will be minimal impact on users, and existing dApps will continue interacting in a similar way. Post-merge would bring high transaction volumes to Ethereum, indicating higher transaction fees. EVM-compatible chains are likely to gain market share during this period.

What is ETH’s short-term performance prediction post-merge?
Major institutions will start pouring money to stake ETH, causing a supply shock. Market moving forward will bring on a second wave of FOMO retail investors to flood the market. Decreased Supply + Increased Demand = Short-term Price Spike.

What is ETH’s long-term performance prediction post-merge?
Gradual improvement towards Eth 2.0 brings more demand, this usage drives value growth. High usage of the chain indicates that whales will continue staking to earn rewards, creating a buying cycle. Since staking requires exactly 32 ETH, investors will be rounding up purchases and introducing new funds to the market. EIP-1559 fee burning lowers supply of ETH over time, making it a deflationary asset.

Ethereum Today

1*CWLBF3m1ewnJmld4D9LgWA.png

This is what the Ethereum that we’re all transacting on today looks like. Whether you’re sending ERC tokens or buying NFTs, all of this is happening on the mainnet that uses a PoW consensus mechanism.

The Beacon Chain runs parallel to the Ethereum mainnet that we use, but has no impact on it currently. It will introduce a new consensus mechanism, PoS, that utilizes staking instead of mining to secure the network.

The goal is to eventually merge the two. Using the Beacon Chain as the consensus layer and the Ethereum mainnet that we’re using now as the execution layer.

The Actual Merge

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The process will be a gradual and continuous merge. At a difficulty the validators on the Beacon Chain coordinate upon, they will start pointing to the execution layer. This means that next time something is built, it will be built by PoS validators and not miners.

Contrary to popular beliefs, The Merge does not mean we’re automatically in Eth 2.0, and that all of Ethereum’s current issues will suddenly be fixed in the blink of an eye.

It’s simply: when the existing PoW consensus is replaced by the PoS consensus. That’s it. It is merely one of the phases in Ethereum’s update path.

1*LVBqRWZyx2D6K7TvWf7cIQ.png

The point from where we are today to fully transitioning Ethereum to PoS is near. The Merge requires more from node operators than previous Ethereum upgrades.

Current priorities are:

  • A few mainnet Shadow Forks without issues
  • Clients passing the various merge test suites
  • Smooth deployments across existing public testnets

Once these things happen, and have been observed for a few weeks, we’ll be set for the merge.

Eth 2.0 Renaming

Many of us have been referring to the post-merge Ethereum as Eth 2.0, myself included. Beyond protocol development, a critical shift in Ethereum has been the movement away from ‘Eth 1.0’ and ‘Eth 2.0’ terminology.

One major problem with these terms is that it creates a broken mental model for new users of Ethereum. They think that Eth 1.0 comes first and Eth 2.0 comes after. Or that Eth 1.0 stops existing once Eth 2.0 exists. Neither of these are true.

The best way to think of this is: 
Eth 1.0 = Execution Layer 
Eth 2.0 = Consensus Layer 
Execution Layer + Consensus Layer = Ethereum

For the rest of the analysis, I’ll refer to what we previously called “Eth 2.0” as “post-merge Ethereum”.

1*NKczEJmax6q0wdPz_kCwsQ.png

Impacts on Ethereum’s App Layer

The Merge is limited in scope to upgrading Ethereum’s consensus mechanism. The stability of the execution layer introduces minimal breaking changes for when the merge does happen. Almost everything will still interact in the same way. The Merge is designed to have minimal impact on users, smart contracts, and dApps.

Without getting into too much of the technicalities, a minor impact that could affect dApps would be block time. Previously in PoW, blocks come in on average ~13s with variance in actual block times. In PoS, blocks come in exactly every 12s. This would impact smart contracts or dApps that assume block time in calculations.

To combat this, EIP-4399 was implemented to provide on-chain apps a way to assess whether the merge has happened. Currently, developers and dApps are encouraged to deploy on testnet to shake out any potential bugs.

Gas Fees

This is what I think is the most misunderstood part of The Merge. Many people are expecting post-merge Ethereum to be this rainbow-filled wonderland where gas fees become super cheap and congestions don’t exist. Gas fees and congestion problems will not be reduced after The Merge.

The way to think of this is through the basic economic concept of supply and demand: 
Gas fee = the price of energy. 
Supply = the space available for computing and storage, aka scalability. Measurement criteria = TPS and block size.

In order to reduce gas fees, supply would need to be increased. Increasing TPS is not plausible because The Merge doesn’t increase computing power. Increasing block size is also not plausible since Ethereum prioritizes decentralization and current block size is at its limit.

Sharding, on the other hand, can increase TPS. However, the integration of sharding would be a long process and not instant like The Merge. In this case, the reduction of gas fees only refer to L2s. The larger the transaction volumes on L2s are, the higher the total fee paid when purchasing L1 block space. In theory, L2 gas fees can be expected to decrease with L1 gas fees experiencing the opposite.

Impacts on EVM-compatible chains

Post-merge will create high transaction volumes on Ethereum, and since The Merge won’t address scalability issues, we can expect much higher transaction fees.

An example is the spike in Polygon’s transactions fees in early 2022 spawned by Sunflower Farmers game attracting high transaction volumes.

1*M_l6NRQCevpbki_N1jesZQ.png

When Ethereum transaction fees skyrocket, EVM-compatible chains are likely to gain market share until sharding is introduced.

Consensus & Execution Rewards

Validators earn rewards in two ways, by producing a block (consensus rewards) and by including transactions in the block (execution rewards).

Execution Rewards
Treated like normal ETH in the sense that it can be transferred, traded, and transacted with. It is available for withdrawal.

Consensus Rewards
The staked 32 ETH per validator + yields. It is currently locked and cannot be withdrawn.

1*2EsQukmxYZtVoiSVg8Bqew.png

Short-term ETH performance prediction

1) Major institutions will make large investments to stake ETH, which would cause a supply shock.

Staked ETH is already wildly popular among traders and investors. We’re also seeing more and more TradFi services offering staked ETH as an investment.

Staked, an asset management fund, introduced staked ETH 2.0 trust to its institutional clients. Switzerland-based Sygnum Bank introduced institutional ETH staking. Goldman Sachs has also started providing institutional clients access to ETH funds.

1*IMsnvavftpdAKoQtGyT8Kw.png

Liquid staking currently makes up ~10% of DeFi TVL. With the introduction of staking post-merge, we will see even more large investors pouring in capital. The supply shock and scarcity in the amount of ETH in circulation would cause a price spike. This is spawned by a sudden removal of large amounts of supply by rent-seeking whales. Those who typically provide market liquidity will also be hesitant to sell.

2) With the initial price spike caused by large investors, market moving upwards will create FOMO among retail investors.

These retail investors typically react late to investing stimulus, and they tend to be heavy-handed and flood markets (as seen in the 2017 BTC bull run).

1*HYPUm15o8pJT6mtyjUMavQ.png

Past major bull market gaps are caused by the difficulty for fiat onboarding. The difference now is that fiat onramp solutions are everywhere. This allows FOMO buyers to enter the market much more easily, heightening demand.

Decreased Supply + Increased Demand = Short-term Price Spike.

Long-term ETH Performance

1) The gradual improvement on Ethereum’s usability will create actual demand from users.

This improvement will be evident in both commercial and consumer viability. With the gradually-updated Ethereum, it will be able to deliver commercial and consumer scale products. This usage drives value growth, and creates real underlying value for the users.

2) When actual use drives up, the rent-seeking whales are back.

The staking mechanism is designed in that the more people stake, the more nodes there are. More nodes mean proportionally lower payouts. Each time a whale adds a node, they’re diluting the potential earning of others. Rent-seekers will need to stake more to continue earning the same rate.

This creates a race condition that results in a cycle of more whales buying to stake.

Since staking requires exactly 32 ETH and can’t be cycled from profits. Investors will need to round up purchases, and in turn will introduce new funds to the market. For example, a whale who made 20 ETH in profits will need to acquire 12 additional ETH to stake the profits.

Whales continue pouring new money into the market to round-up their stakeable amounts can be explained by opportunity costs.

1*maA0WINuEv2ug5P3j1kRDw.png

Idle ETH gains X% per year, and staked ETH gains (X% + Y%) per year. Investors will almost always choose to stake more ETH if gains are guaranteed.

3) EIP-1559 introduces fee burning that could start to lower overall supply of ETH.

Early estimates start off at ~10K ETH burned/year and will grow with use. Long run expectation = ETH burned per year > ETH issued per year.

1*obtlNDIEz_WH8TLpzDP3Hw.png 1*YWeCS9zU5dkXdz2S99frKg.png

There will be an estimated 90% reduction in ETH issuance post-merge. The supply growth as simulated on ultrasound money will go from +3.8% per year to -0.3% per year. This is a strong indicator that ETH could gradually become a deflationary asset.

ETH Projection Stats

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According to the Ethereum website:
Total staking amount on the Beacon Chain has exceeded 13M ETH, and the total number of validators has reached 389,307. Current APR sits at ~4.3% and total value of ETH staking has exceeded $26B.

Difficulty Bomb

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The chart above demonstrates blocks produced per week as an indicator of the difficulty bomb. Blocks produced per week stands in for the number of seconds it takes on average to produce a block, which stands in for the effect of the difficulty bomb.

The vertical dashed grey lines are the hard forks. The horizontal grey dashed lines are how many blocks would be produced in a week if the per-block production were 14 seconds, 16 seconds, 18 seconds, etc.

The slight dip could indicate that we will start seeing an effect of the bomb.

1*Xy_QaNHRPPGj3qv7vPCrEA.png
The chart above is a prediction for block times assuming hashrate stays consistent. This is based on reported block timestamps which may differ materially from the actual time between blocks.

Some final thoughts

Personally, I think one of the reasons people are/will be so bearish on post-merge Ethereum is due to a lack of understanding of what exactly The Merge will bring. Expectations that gas fees will be reduced, and congestion problems will be fixed are among the most popular misconceptions. Again, The Merge will not fix these, it is simply when the existing PoW consensus is replaced by the PoS consensus.

Another misconception is that ETH will dump hard when >13M ETH get unlocked after The Merge. Staked ETH will not be unlocked at The Merge, it won’t enable withdrawals until months after. Even when withdrawals are enabled, the staked ETH won’t all immediately be flushed to the market. There will be an exit queue, just like there is an entry queue, which may take anywhere from a few months to more than a year. Release will be slow.

Hopefully, this analysis has highlighted the accurate expectations of what’s to come.

A lot of people are really fixated on when The Merge will happen, to the point where they shit on Ethereum whenever they hear there will be a delay again. IMO, there’s really no point in debating when The Merge will happen if you don’t look at things in a grander perspective and analyze what this merge will do to Ethereum both short-term and long-term.

One last thing I would like to point out is a potential risk of miners refusing to merge. There is a possibility that they would all refuse to move to PoS and decide to fork an alternative version of Ethereum like ETC. But, if that does happen, whichever version of Ethereum is the most mainstream (listed on exchanges, used, etc.) will emerge victorious.

Obviously, given the short-term and long-term performance predictions I’ve made, my pov is bullish on ETH. The most optimistic scenario would be Elon Musk buying ETH after seeing its potential and tweeting about it, lol.

Thanks for reading all the way. This is one of my more critical R&A that’s a bit more serious than the usual project analyses I write. Might post more of these in the future, might not.

-SixOhFour

Sources:
https://www.youtube.com/watch?v=8N10a1EBhBc&t=810s
https://ethereum.org/en/upgrades/merge/
https://blog.ethereum.org/
https://tim.mirror.xyz/sR23jU02we6zXRgsF_oTUkttL83S3vyn05vJWnnp-Lc
https://docs.ethhub.io/ethereum-roadmap/ethereum-2.0/eth-2.0-economics/
https://docs.google.com/spreadsheets/d/1vrK5sY5ooq-F8dcyRhmmAJ5YtgkvWKWP3OfGCZIYxSA/edit#gid=0
https://ethresear.ch/t/blocks-per-week-as-an-indicator-of-the-difficulty-bomb/12120/8

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The Oasians

From beginner 101s to deep dives, we create content for crypto projects. Join us and discover the limitless possibilities of crypto. We also write an Oasian's Digest newsletter that rounds up daily crypto news straight from crypto twitter, so make sure to subscribe on our Twitter profile for that. https://twitter.com/theoasians

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