Insights

Ethereum Merge

What is the Merge? 

As the use of cryptocurrencies has proliferated, so has the energy consumption required to maintain their underlying blockchains. Digiconomist estimates that Ethereum consumes 112 terawatt-hours of electricity per year. This is equivalent to the entire consumption of the Netherlands. With issues of sustainability at the fore, Ethereum has sought to take action, switching its consensus mechanism (where most of this energy consumption is derived) from a Proof-of-Work (PoW) to a Proof-of-Stake (PoS) system. This process, which is due to be completed on the 19th September 2022, is commonly referred to as the ‘Merge’, 

Proof-of Work vs Proof-of-Stake

To operate successfully, the nodes on a blockchain must come to an agreement on the network’s current state at regular intervals. This requires some nodes to validate any new blocks which have been added during that interval. The process through which this happens is called a consensus mechanism. 

There are two leading consensus mechanisms, Proof-of-Work (PoW) and Proof-of-Stake (PoS). PoW is used by both the Bitcoin network and the existing Ethereum Mainnet network. Nodes compete to produce a valid block, which requires raw computational power. The winner receives cryptocurrency as a reward. This process is known as ‘mining’, in which miners expend electricity for the potential to earn cryptocurrency rewards. In contrast, the PoS mechanism requires block validators to ‘stake’ cryptocurrency. This stake is held as collateral in return for the chance to earn rewards from validating blocks. The stake can be ‘slashed’ as a penalty to deter bad actors, thus aligning incentives. Ethereum estimates that the switch from PoW to PoS will reduce the network’s energy consumption by 99.95%. 

Why is it called the Merge? 

The Ethereum network is currently operated by Mainnet, the PoW-based blockchain. In December 2020, a PoS network called the Beacon chain was launched and has been running in parallel since. The Merge describes the process through which the Beacon Chain replaces the Mainnet as the consensus protocol, combining the entire history of Mainnet along with it. 

What are the other benefits of this Merge? 

As discussed, the main rationale behind this upgrade is reduced energy consumption. However, this shift will indirectly make the Ethereum network more scalable by allowing for ‘sharding’, a future upgrade which makes more block space by splitting the network. Since transaction fees (gas fees) are determined by the supply and demand for blocks, this will help decrease fees. The Merge is a necessary precursor to this upgrade. 

What does this mean for the price of Ether? Notes from the trading desk

The value of Ether appreciated as the likelihood of a successful Merge became more apparent, producing outsized returns in comparison to PoW tokens.  Similar increases were enjoyed by other PoS assets, such as Polygon, reflecting the wider shift from PoW to PoS as the market unwinds the cost of high energy usage and the associated regulatory risk. Financial institutions have been restricted in allocating capital to Ether in part due to their ESG targets, so the switch to the more energy-efficient PoS mechanism removes this constraint. Nonetheless, Crypto is still a high-beta asset and Ethers price action has been capped in the short term by a broader market pullback. The market has struggled to sustain its rally as talk of a potential Fed pivot has been cooled by a return to hawkish rhetoric and a run up in yields, hurting risk asset valuations across the board. Derivatives markets are pointing towards a ‘sell the news’ event leading up to the Merge. Volatility smiles lean bullish into September 19th and bearish post. With huge open interest in Ether at the moment, surpassing Bitcoin for the first time ever, we could see derivatives markets leading spot markets. This move has been flagged by many desks though, and as it becomes more scripted so does the appeal of taking a contrarian stance in the market.  As always, our trading desk is on hand to support you through this event.

Will it affect my ETH holdings? 

No, ETH holdings will be unaffected, since all information from the PoW blockchain will be carried over. As an asset owner you do not need to do anything during this period. Please keep an eye out for scams. 

There has been lots of noise regarding staked Ether. Currently, Ether that is staked cannot be unstaked, however there are whispers this will change after the Merge. For more information, visit: https://ethereum.org/en/upgrades/merge/


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