Web 3 Series #1: Ethereum 2.0 - Everything you Should know
FINE#8385
0x1552
September 10th, 2022

Author(s): Alan Nguyen | L3#4569

Editor(s): FINE#8385

Last updated: 10th Sept 2022

Ethereum 2.0 and the Merge event have been attracting lots of attention since the speech of Vitalik Buterin during the Ethereum Community Conference in Paris 2022. This radical blockchain upgrade was predicted to have a huge impact on the crypto industry as well as its native coin, Ethereum (ETH). This article will deeply dive into this important upgrade and how it can embark on the new revolution of layer 1 blockchain.

Ethereum problem

Before explaining Ethereum 2.0 and its mechanism, we first need to understand why we need this upgrade in the first place. It’s due to some issues with the current Ethereum blockchain, including extremely high gas fees, energy consumption, low transaction speed, and limited scalability due to decentralization.

The transaction fee was raised up to the ATH of $25.43 in 2021 (Source: Ychart)
The transaction fee was raised up to the ATH of $25.43 in 2021 (Source: Ychart)

Ethereum is the first ever blockchain network that successfully solves the Bitcoin scalability issue and allows developers to build applications upon it, using $ETH as its native coin. It is understandable that Ethereum still remains the most popular layer 1 blockchain with millions of active users and developers on the network. However, due to the surge in the number of transactions, especially during the uptrend 2020-2021, this sheer demand drives up the gas fees. This is also the result of its own consensus mechanism, Proof-of-Work (PoW), where each interaction requires an extensive amount of computing power from each miner to approve and be added to the block. Compared to some of the other new layer 1 networks, they use Proof-of-Stake (PoS) to cut down on energy costs and propose more efficient interactions and scalability. Therefore, Ethereum networks face much higher gas fees and slower throughput, gradually losing their potential users to other newly born Layer 1 networks with more advanced technology.

$ETH's market share by TVL on DeFi Llama has declined from 100% to 55% in the space of 2 years.
$ETH's market share by TVL on DeFi Llama has declined from 100% to 55% in the space of 2 years.

How can Ethereum 2.0 solve the problem?

Ethereum 2.0 is the process of transferring its old consensus mechanism, Proof-of-Work, to the new Proof-of-Stake, along with the sharding upgrade in order to make the network more secure, scalable, and sustainable.

For you to better understand how significant this upgrade will be, you need to understand the difference between these two mechanisms:

  • Proof-of-Work (PoW): Miners will use the power of the miner to solve problems that generate hashes. After solving, they will gain the right to validate transactions and add new blocks to the blockchain.

  • Proof-of-Stake (PoS): This mechanism will not have miners like PoW, but instead participants who validate transactions will have to stake large amounts of coins to win the right to validate transactions and block generation. Therefore, PoS does not require many expensive miners and still ensures high performance.

Therefore, the PoS transition will help Ethereum overcome the old disadvantages of the PoW system: high energy consumption, and large commission rate due to huge mining rewards. On the other hand, the new sharding upgrade will be another important process to enhance Ethereum’s performance and scalability.

Ethereum 2.0 Update Plan

This huge improvement consists of 3 major upgrades: The Beacon Chain, The Merge, and Sharding.

1. The Beacon Chain

This phase will introduce Pos consensus to Ethereum by being developed as a separate and parallel chain (or consensus layer) to the Mainnet (or the execution layer) with the native token, ETH2. Users are allowed to transfer from ETH1 (old Ethereum chain) to ETH2 to stake and receive rewards as validators for the network.

After about a year of going live since 2020 (not yet merged with the Ethereum network), Beacon Chain has had impressive numbers as follows:

  • Number of active validators: >326,000.

  • ETH staked on Beacon: >10,400,000 ETH.

  • Staking Rewards: 4.06% APR

2. The Merge

The Merge will be one of the biggest upgrade events for the Ethereum network, where the blockchain will be officially upgraded to the PoS consensus mechanism. It will permanently eliminate the extensive use of energy from mining and instead secure the network by staking ETH.

This huge event will significantly affect the supply of ETH, in which the ETH issuance from the execution layer will go to zero as the PoW consensus mechanism will be completely removed. ETH issuance is the process of creating new ETH that did not previously exist in order to reward validators of the network. Currently, the Mainnet chain (Execution Layer) issues 13,600 ETH/day for miners, while the Beacon chain issues only around 1,600 ETH/day for stakers. After the Merge event, only around 1,600 ETH per day rewards will be produced, reducing the total new ETH issuance by nearly 90%.

This upgrade indicates that the total supply of new ETH will be created much slower, with only around 0.49% per year. Moreover, there was also the EIP 1559 upgrade implemented by Ethereum developers, which burns the base fee per gas. This change has raised the total number of burned ETH per day. Over 2.5M ETH has been burned and completely removed up to this point. The current burning rate at the time of writing is 0.94 per minute, which is around 1,353.6 ETH per day; thus, it decreases the inflation rate significantly. Indeed, ETH can also be deflationary during the peak period as the burning rate will increase according to the surge in gas fees.

The Merge will also mark a turning point for the future growth of the crypto industry as all the environmental concerns around Ethereum will be eliminated. Specifically, the PoS transition will eradicate all mining activities, reducing the level of energy consumption by 99.5% as staking does not require computing power. This is an important point as environmental concerns are becoming a key stakeholder consideration in the modern era. A sustainable and eco-friendly blockchain model will definitely give Ethereum a competitive advantage compared to other Layer 1 networks. Ethereum will lead the way to a whole new era of environmentally sustainable blockchains.

The staking APR rewards are likely to be increased after the Merge event as every stakers will not only receive the basic issuance but also tip fees from users. When users make a transaction, the gas fees will be divided into base fees for burning and tip fees for validators. It will raise the APR rewards for validators; thus, users are incentivized to stake their ETH to sweep this juicy APR. This result, in turn, can cause a supply shock for ETH, which can positively affect the price of ETH.

This upgrade event is scheduled for Sept. 16, 2022, and is likely to be one of the biggest events in the crypto industry. It is recommended to follow their updates as this occasion may change the course of the crypto market forever.

3. Sharding

After the biggest upgrade to make Ethereum sustainable and deflationary, the sharding phase will enhance its scalability and capacity significantly. Vitalik Buterin claims that after this phase Ethereum will be able to process "100,000 transactions per second".

The Founder of Ethereum has also updated the details of this phase after the Merge during the conference in France, including 4 important milestones:

  • The Surge

  • The Verge

  • The Purge

  • The Splurge

Upcoming upgrade plan after the Beacon Chain phase
Upcoming upgrade plan after the Beacon Chain phase

The surge refers to the introduction of Ethereum sharding. This solution will split a blockchain's entire network into smaller partitions, known as "shards." Sharding will work synergistically with layer 2 rollups by splitting up the burden of handling the large amount of data needed by rollups over the entire network. Once completed, this will reduce network congestion and increase transactions per second for Ethereum. This upgrade is scheduled to be implemented in 2023.

Sharding mechanic explanation (The Surge)
Sharding mechanic explanation (The Surge)

With the Verge, Vitalik introduces verkle trees, a "powerful upgrade to Merkle proofs that allow for much smaller proof sizes." These technical upgrades will allow users to become network validators without storing extensive amounts of data on their machines. As a result, it assists the network in optimizing storage on Ethereum and reducing node size. Buterin believes that the verge will be “great for decentralization.”

Next, the Purge phase will reduce the hard drive needed for validators, trying to eliminate historical data and bad debt. This solution should eventually help validators free up storage space and minimize network congestion.

And finally, the Splurge, “it’s all the fun stuff”, according to Vitalik Buterin. While we don't have much detail, this phase will be expected as a series of miscellaneous upgrades to ensure the network runs smoothly following the prior 4 stages.

All of these upgrades after the Merge are still in the tech development phase, but we can confidently claim that these events will mark a celebratory phase for the Ethereum network - to become the most secure, scalable, and sustainable layer blockchain.

Potential Impacts on Layer 1 and Layer 2

This is probably one of the most frequently asked questions “Will layer 1 and layer 2 solutions survive after the Merge?” I chose to talk about the Merge specifically because this event is highly anticipated in 2022 and it can provide huge improvements for the Ethereum network. Below are some of my theories.

Potential impacts on Layer 1

Layer 1 is the base level of the blockchain infrastructure. Ethereum (ETH), BNB Smart Chain (BNB), and Solana are examples of layer 1 protocols. These layer networks will have their own mechanism to process transactions and allow other applications to build upon it. They also issue their own native token used to pay transaction fees.

As Ethereum and other blockchain networks are in the same layer 1 category, they have been competing to attract crypto users through loads of community incentives and opportunities. Over the years, it has become the fact that Ethereum is losing its market share owing to other L1 solutions with lower gas fees and better user experience. But what if the King of Altcoin comes back, with better solutions to solve all its current drawbacks? It will be a matter of time before users come back to the first layer 1 because most of the best projects originated from Ethereum.

However, it would be a long process, especially during the sharding period, it would take about 2-3 more years of development for Ethereum to reach its full potential in scalability. It will probably give enough time for other new layer 1 solutions to build users and generate their own network effects. We have seen many L1 experiencing huge growth, such as Terra (LUNA), Solana (SOL), or Fantom (FTM) in 2022. Even if the Ethereum network is able to scale, there is still a massive need for new layer 1 solutions in order to onboard billions of crypto users in the future.

Potential impacts on Layer 2

While Layer 1 is the base level of the blockchain infrastructure, Layer 2 refers to networks that are built on top of other layer 1 blockchains. These blockchains will operate in parallel or independent of the main chain, inheriting some of the unique advantages of Layer 1. For instance, Ethereum is the layer 1 blockchain with the best security, but it has been facing numerous issues related to its limited scalability and high gas fee. Therefore, lots of Layer 2 scaling solutions such as Polygon, and Optimism were created to fix these problems and take advantage of Ethereum’s secure network to provide a better experience for users.

But this scalability issue will be solved when Ethereum finishes its sharding phase right? What is the point of having layer 2 scaling solutions? According to Alan Chiu, CEO/Founder of Boba Network, a Layer 2 Optimistic Rollup scaling solution, argued that: “As Ethereum L1 becomes more efficient, L2’s will simply become that much more efficient right alongside, all while maintaining their current added benefits.” I agree with this point of view that layer 2 will be the necessary add-in for the main chain. Especially after the Merge, Ethereum transaction fees won’t be reduced as this upgrade only changes the tokenomics; sharding technology will do the work. But the last phase is the long-term process, so L2 solutions are still in demand to offer lower gas fees and proceed with transactions. If Ethereum can finally be able to scale, layer 2 can also scale thanks to the synergistic model of the surge.

Conclusion

That’s everything you should know about the upcoming upgrade of Ethereum and its potential effects on the crypto industry. From my personal perspective, Ethereum 2.0 will have a positive impact on the Ethereum ecosystem when it is managed to become more secure, sustainable, and scalable. The change in the tokenomics after the Merge would affect the price of ETH positively as it makes ETH deflationary in the long term (NFA!). It can be predicted that Ethereum will still keep its top position and may take back its market share once the upgrade is completed. However, it would be a long process and other layer 1 blockchains should take this advantage to act quickly and position themself on the market.

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