The Ethereum 2.0 Merge: What It Means For The Network?

In a milestone update known as “the merge” on September 15, Ethereum shifted from an energy-intensive system to a more sustainable one. Eastern time. After years of work and delay, the huge revamp of Ethereum converts the digital machinery at the core of the second-largest cryptocurrency by market value to a considerably more energy-efficient system.

There was a great deal of expectation and conjecture over the new dynamics of Ethereum’s Merge. Years of planning ensured that most network members on Day 1 would notice just minor changes. However, there are still misunderstandings regarding The Merge’s accomplishments.

No, gas fees didn’t drop. No, network throughput didn’t increase overall. However, The Merge did make drastic changes to the infrastructure and incentives of the network. All Ethereum ecosystem network participants will ultimately feel these modifications. This includes significant changes to block confirmation times, new transactional risks associated with MEVs, and new economic incentives.

This article will explain what The Merge is, what it changes and does not alter on Ethereum, and how these changes may affect you as a user, web3 developer, trader, or validator.

What is The Merge?

As measured by overall economic activity, user growth, and developer involvement, there is little question that Ethereum is the heart of web3 Proof-of-Work (PoW) to Proof-of-Stake (PoS) consensus.

Proof-of-Work (PoW) requires miners to confirm blocks by solving cryptographically challenging computation puzzles – consuming energy along the way (literally, the ‘proof-of-work’). Hash power, or the total amount of computation (and hence energy) allocated to safeguarding a PoW public blockchain network, is a measure of the network’s overall security. Because mining involves specialised equipment and skills, a limited number of privately owned mining pools formerly controlled the bulk of Ethereum’s hashing power.

However, in Proof-of-Stake (PoS), validators stake ether into an Ethereum smart contract rather than solving cryptographic puzzles. This staked ether serves as collateral that can be forfeited if the validator engages in dishonest or unreliable behaviour. Because anybody with 32 ETH can operate a validator under PoS, network control is divided among a far larger number of participants than under PoW. Individuals with fewer than 32 ETH can also profit from staking by joining mining pools like Rocket Pool or Lido or trading on a centralised exchange.

The Path to the Merge. Image: Bitcoin.com

But what exactly was the “merging” process happening during The Merge?

“The Merge” signified the merger of the Ethereum mainnet execution client with the Beacon Chain Proof-of-Stake consensus client. Despite post-Merge Ethereum being referred to as Eth2 or Ethereum 2.0, The Merge is a network update and not the formation of a new coin or network, as the term “Eth2” may suggest. Both an execution client (Eth1) and a consensus client (Eth2) are required to run a complete Ethereum node after The Merge.

• Eth1 → execution layer
• Eth2 → consensus layer
• Execution layer + consensus layer = Ethereum

The Execution Layer is in charge of state storage and administration, state synchronisation, execution of virtual machines, transaction processing, mem pools, etc. The Consensus Layer incorporates the Ethereum blockchain modifications that the Beacon Chain introduced, most notably the switch from proof-of-work (PoW) to proof-of-stake (PoS) (PoS).

Due to the Execution Layer’s reliance on current Ethereum clients, retaining it made the network’s shift to proof-of-stake easier for dapp developers since no migration was required on their end.

Why Replace Proof-of-Work (PoW) with Proof-of-Stake (PoS)?

There are three primary reasons why Ethereum moved from a Proof-of-Work to a Proof-of-Stake system:

• PoS leads to a more secure, decentralised network.
• PoS enables scalability through sharding.
• PoS uses at least ~99.95% less energy than PoW.

PoS leads to a more secure, decentralised network.

Due to the high cost of mining, few participants can individually validate, and most individuals engage in mining pools. Consequently, mining pools construct and propose the majority of blocks. This leads to a small number of highly centralised network administrators. According to the cryptocurrency analytics firm Crypto Compare, five Ethereum mining pools produced 65.4% of all ETH mined in 2021.

Under Proof-of-Stake, Ethereum requires a minimum of 16,384 validators, making the network’s security far more decentralised and significantly safer.

PoS enables scalability through sharding.

Transitioning the network to PoS was the initial step towards allowing sharding, which is an attempt to divide the network into “shard chains” that share the load of Ethereum, thus lowering network congestion and boosting transaction throughput. Rather than resolving all transactions on a single blockchain, these shard networks distribute transactions among 64 new chains. Planned to begin in 2023, shardingwill enable the network to scale at an unprecedented rate.

Danksharding, a more recent sharding scheme, is gaining favour in the Ethereum community. Danksharding simplifies earlier sharding solutions significantly and introduces the idea of Proposer/Builder Separation (PBS). Later in this blog, we will discuss the potential ramifications of separating block building from block proposing.

Once completed, sharding is anticipated to raise Ethereum’s transaction throughput to 100,000 transactions per second, which would be higher than the throughput of all major credit card firms.

PoS uses at least ~99.95% less energy than PoW.

Before the Merge, Ethereum consumed around 83.89 TWh of power yearly, which is close to Finland’s usage. Proof-of-work computations do not require enormous amounts of energy on PoS. According to Digiconomist, PoS is ~2000x more energy efficient, with a reduction of at least 99.95% in total energy use.

Relative energy consumption per transaction. Image: Ethereum Blog

What changed after The Merge?

The Merge brings several critical changes to Ethereum, such as:

• Miners were replaced by validators.
• Increased time to block finality.
• New penalties add stakes to staking.
• Block building creates new economic actors.
• The block reward subsidy decreased by ~90%.
• Fixed block times may affect MEV dynamics.

Miners are replaced by validators.

In the transition to PoS, miners were replaced by validators. To participate as a validator, one no longer needs a sophisticated mining rig but rather 32 ETH to stake and three distinct pieces of software: an execution client, a consensus client, and a validator.

Validators propose new blocks, provide attestations (votes), and watch for slashable infractions (penalties).

A validator will stay active until:

• It voluntary exits
• Its balance drops below 16 ETH
• It gets SLASHED

Increased time to block finality

Today, Beacon Chain blocks take 64-95 slots (15 minutes) to complete, which is a considerable increase from the less than five minutes it took to wait for 35 block confirmations. At this point, it was generally accepted that a transaction was secure and confirmed under PoW. Why is block completion so much slower under PoS? To comprehend this, let’s examine at a high level how block finality functions after The Merge.

Under PoS, every slot (12 seconds) is filled with a block, even if it is empty. The network chooses a validator at random to be the proposer for each slot. If the validator fails to propose a block during their given slot, the network will not have a block in that slot and will go to the next slot.

If a block is formed, other validators on the network receive it, check its validity, and cast an attestation (vote) in its favour.

Each validator on the network can cast one attestation (vote) in support of the epoch every 32 slots (6.4 minutes), also known as an epoch. It takes two justified epochs (a “justified” epoch is one in which the majority of validators agree) for those epochs and all of their blocks to be declared finished. Once a block has been completed, its reversal needs at least one-third of all validators to burn their deposits, projected to cost more than 3 million ETH.

This new approach to block finality may be slower, but it is far more secure than the “longest-chain” criterion found in Proof-of-Work (PoW) blockchains and less likely to lead to double-spend attacks or hard forks.

Block finality comprises several other levels beyond this article’s scope. For a detailed explanation of block finality, please visit https://kb.beaconcha.in/glossary. To learn more about Vitalk’s ideas around Ethereum’s path towards single-slot finality, check https://notes.ethereum.org/@vbuterin/single_slot_finality.

New penalties like “Slashing” add stakes to staking.

Validators can also monitor each other for malicious behaviour and “slash” other validators for failing to protect network security. Slashable violations include multiple voting (e.g., proposing two blocks in the same slot) and presenting contradicting attestations, which are provably against the Ethereum network (e.g. signing two different attestations in one epoch).

Validators that look for events that can be slashed are known as “whistleblowers” or “slashers.” When a whistleblower discovers a slashable occurrence, they will notify the network so that the next block proposer can include the evidence in their block. In return, the block proposer will be rewarded for slashing the malicious validator. However, the whistleblower does not earn a reward. This is because whistleblowing is intended to be selfless and not lucrative.

Understanding that slicing is not always motivated by malice is also essential. Validators can also be terminated for laziness and lack of network participation. Similarly, a validator can be slashed because of purely negligent behaviours, such as not maintaining up-to-date protection on failover servers or employing duplicate keys.

When a validator is attacked, they gradually lose ETH. The precise sum will change based on network activity. Slashed validators may be excluded from the protocol and forcefully removed from the network permanently.

Inactivity fines are the loss of cash suffered when a validator is inactive or unable to complete its validation tasks.

Block building creates new economic actors.

Transactions on public blockchain networks are grouped into blocks. After blocks are verified (or validated), they are put into the blockchain. Block construction is the process of deciding which transactions are included in a block and in what sequence. And, as you might anticipate, transaction inclusion and ordering may significantly influence how value transfers within the network and to whom.

Under Proof-of-Work, block construction and mining (i.e. proposing and validating a block) were handled by the same network actor. Since mining involves specialised equipment and experience, a tiny group of mining pool operators became accountable for the bulk of block building, rendering this opaque and centralised.

This changed – fundamentally – with The Merge.

While block construction and proposal are still the responsibility of a single entity — the validator — the massive flood of additional validators will likely result in many participants who lack the expertise to construct optimal, lucrative blocks the way miners could.

As a result, The Merge fosters the emergence of Block Builders, a new class of core network economic operators. These block builders are specialised suppliers that compete in a real-time market to produce blocks for validators on their behalf. Eventually, the network will codify this split between block builders and block proposers as the Proposer/Builder Separation (PBS).

The separation of block construction and proposing generates new types of economic players with far-reaching repercussions and potentially new, distinct, and maybe even concealed power structures. Block building will likely have a more significant influence than many anticipate; for instance, new dynamics caused by block building might result in your web3 wallet or decentralised application paying you to use it.

Block reward subsidy decreased by ~90%

Under PoW, miners were rewarded with newly minted ETH for successfully adding a block to the blockchain. Under PoS, validators who correctly propose new blocks are also rewarded. However, with Proof-of-Stake, this block reward is decreased by approximately 90%, as validators no longer pay the costs associated with mining and hence require less network subsidy.

According to the Ethereum Foundation, ETH supply under PoS significantly lessens Ethereum’s sell pressure. According to Ethereum.org, the difference between mining and stake rewards is as follows:

• (Pre-Merge) PoW Mining rewards: ~13,000 ETH/day pre-merge
• (Pre-Merge) Staking rewards: ~1,600 ETH/day pre-merge
• (Post-Merge) Only the ~1,600 ETH per day remain, dropping total new ETH issuance by ~90%

This phenomenon is known as triple halving.

During the London Hard Fork in August 2021, the deployment of the EIP-1559 upgrade added a burning mechanism for ETH gas fees. ETH may become a deflationary asset post-Merge due to the fall in block rewards and the burning gas base fees.

Fixed block times may affect MEV dynamics.

The Merge has resulted in a significant change: fixed block times. The earlier PoW paradigm had flexible block times, allowing blocks to be validated at any time. Under this method, each millisecond was equally “useful”; miners and MEV searchers could not anticipate precisely when the next block would be verified.

Under PoS, blocks are verified precisely every 12 seconds. This means that every millisecond is no longer equivalent to every other millisecond since those closest to the block confirmation carry a higher value for specific trading methods, hence giving rivals less time to react. This can lead to surge effects when the last second or two before a block is verified experience a spike in transaction volume.

There are shorter time frames for automated systems to compete, driving competition for infrastructure with reduced latency to detect and respond. This will undoubtedly affect gas prices, but further data collection is required.

A substantial amount of cash is being spent investigating and determining how fixed block periods affect gas prices. Post-Merge is anticipated to be a phenomenon that impacts the whole network and the character of the gas market.

What stays the same after The Merge?

While The Merge resulted in fundamental changes to how Ethereum operates internally, consumers did not notice any significant changes to gas or transaction throughput.

• The Merge does not affect Ethereum’s existing gas pricing methodology; EIP-1559 is still in use.
• The Merge did not reduce gas fees. Blocknative is observing how fixed block times affect transactional patterns and how these new patterns affect the gas market.
• The Merge did not improve Ethereum’s transaction throughput. Not until the launch of sharding in 2023 is this anticipated.

What Happens Next?

The Merge is simply one in a succession of anticipated Ethereum blockchain improvements. The Shanghai upgrade is the next update. After Shanghai, Ethereum is anticipated to experience the “surge,” the “verge,” and the “purge.”

The “surge” refers to the introduction of “sharding” technology, which is predicted to enhance Ethereum’s maximum transaction processing pace from 15 to 20 transactions per second to about 100,000 transactions per second.

The “verge” is the proposed implementation of a mathematical proof known as “Verkle trees” that will allow nodes on the blockchain to operate without downloading the complete chain’s history.

The “purge” will conclude with erasing of old data on the chain. These three enhancements will result in a smaller, easier-to-use, and significantly quicker blockchain.

The Merge signifies a fundamental shift in the Ethereum blockchain’s functioning and is the most significant alteration to a blockchain’s core operation in history. The Merge will likely have far-reaching and unanticipated repercussions, which will be covered in future posts.