The Merge

July 2022 Commentary

In July the crypto markets continued to rebound alongside the general improvement in the risk assets despite the eye watering inflation numbers and continued tightening of financial conditions by central banks around the world with ECB joining the fray with their first hike. Despite the ongoing tightening of financial conditions, the markets are pricing an end to tightening with easings actually priced for 2023. A US recession which just started may force the Federal Reserve to cut rates as early as next year.

The contagion effect from the fallout of Terra, Three Arrows Capital, and Celsius certainly gave July one of the most eventful months in its history. After ghosting for several weeks, the founders of 3AC finally broke their silence with comments that were anything but an apology in an interview with Bloomberg. Several exchanges around the globe have halted customer withdrawals, and a few well-capitalized firms such as FTX and Nexo have been stepping in to pick up distressed crypto assets.

The regulatory battle in crypto continues. The US Treasury published a fact sheet outlining a framework for international collaboration on a path forward for regulation.

Ethereum and Bitcoin have both seen an uptick in on-chain activity in tandemwith the rally in their prices, however ETH has outperformed BTC in the “merge” rally in anticipation of the much-awaited update to the network.

What is the Merge?

Ethereum Mainnet is expected to deploy its much-awaited ‘merge’ in September. This has been a much-anticipated and frequently-delayed upgrade to the Ethereum network that changes its consensus mechanism from Proof of Work (PoW) to Proof of Stake (PoS). The switch to PoS primarily eliminates the need for the energy-intensive mining and instead secures the network using staked ETH.  After the merge, the validators will receive the fees from creating a block, fees that are currently going to the miners.

Why Proof of Stake? 

No consensus mechanism is perfect. While Bitcoin pioneered the PoW consensus mechanism, it has several drawbacks that make the switch to PoS a necessity for the long-term viability of Ethereum. One is the much-debated energy required for PoW, another is the need for 100% uptime of the network’s hash rate that can be entirely external to the network. In a PoS, the majority attacks are harder given that an attacker has to amass enough financial stake and the hardware required.

Common Misconceptions

It is important to also understand what the Merge is not. The most common misconceptions are that the merge will lower fees, greatly expand capacity, or speed up the Ethereum’s network.

The Merge is not an expansion of the network capacity. Rollups (here already) and sharding (incoming) will expand the network’s capacity.  Neither will the merge lower fees; L2 scaling solutions are for the moment dealing with lowering gas fees.

There is an excellent page on the ethereum.org website that addresses several of the common misconceptions in-depth.

What is the Impact of the Merge on the ETH Price?

The merge will greatly reduce the issuance of ETH given that the mining rewards are no longer necessary. This should substantially reduce daily issuance of ETH to almost net zero post-merge. All else equal, the reduced supply should increase the price of ETH some of which we are seeing in this “merge-rally” as the date is becoming firm.

What is Next After the Merge? 

The merge is the first phase of the several concurrent developments in Ethereum. Vitalik’s roadmap is still loosely the path ahead. It describes four stages coming after the merge:

The Surge will introduce sharding and significantly scale network capacity.

The Verge will introduce verkle trees, the purge, and the splurge on the horizon.

The Purge will reduce the hard drive requirement for running validators and nodes.

The Splurge is the catch-all term for everything else to come.