How Ethereum is changing in 2022 & what the impact will be

Ethereum is likely to face the most significant transformation in its seven-year history near the end of 2022. The Merge will convert Ethereum's consensus process from Proof of Work to Proof of Stake. Not only will this make Ethereum more environmentally friendly, but it will also drastically reduce ETH issuance and provide the groundwork for massive scalability improvements.

Since its inception in July 2015, Ethereum has used the same Proof of Work consensus process as Bitcoin. That will all change when the Beacon Chain, which has been running Proof of Stake since December 2000, merges with the main Ethereum blockchain during the Merge. From then on, Ethereum will use Proof of Stake to reach consensus.

This is the comparison used by the Ethereum official website to explain the monumental update in layman's terms:

“With the Beacon Chain, the community has built a new engine and a hardened hull. After significant testing, it's almost time to hot-swap the new engine for the old mid-flight. This will merge the new, more efficient engine into the existing ship, ready to put in some serious lightyears and take on the universe.”

Ethereum.org

To grasp the significance of Ethereum's shift to Proof of Stake as a “new engine,” you must first understand blockchain Consensus Methods.

What is a consensus method？

A consensus technique is the mechanism by which a blockchain (a distributed network of independent computers) establishes agreement on the accuracy of new entries in a shared ledger.

In the case of Bitcoin, a novel form of monetary system, the shared ledger is updated to reflect unspent recent transactions as well as the amounts of bitcoin kept in UTXOs (unspent transactions), which are the equivalent of account balances.

Ethereum functions as a computing engine, dubbed the “world computer,” as well as a monetary system denominated in Ether (ETH). As a result, agreement must be achieved on the state of calculations (performed via Smart Contracts) for supporting digital applications (dApps) and account balances holding Ethereum. Both are saved in something known as the Ethereum Virtual Machine (EVM)

Proof of Work gets its name from network participants, known as Miners, who must verify that they have done enough work to add fresh blocks of data to a shared ledger known as a blockchain.

To answer a math puzzle, the required task is to continuously run a specified software program, consuming electricity in the process. The winner receives a bitcoin or ether award as well as the ability to publish a new block.

The electricity usage of Proof of Work creates what economists call a negative externality; Bitcoin and Ethereum gain security, but the rest of the world must deal with the C02 emissions.

Because one of the fundamental qualities that gives money value is scarcity, consensus mechanisms govern the currency supply schedule (the rate at which new coins are added), which affects pricing.

Miners receive fees for transactions added to new blocks in addition to the block reward. Because competition for limited block space drives up prices, the Consensus Method is critical in incentivizing Miner involvement and calculating transaction costs.

Proof of Work encourages good behavior because it makes no sense to waste energy by attempting to add invalid transactions to new blocks that the rest of the network would reject.

To successfully add new blocks with fraudulent data, bad actors must control more than 51% of the overall Mining power, known as Hashrate. To discourage cooperation, it is critical that the barrier to entry for Miners be low.

The ease of downloading and storing the entire blockchain, as well as running the software that incorporates the consensus rules, is part of that barrier to entry. As a result, the Consensus Method is critical to the overall system's security.

The Consensus Method creates new blocks of predetermined size and pace - for Ethereum, this represents a limit of around 15 transactions per second. This defines how scalable the system is, because if the rate and size are set and transaction demand increases, the cost of transactions will only rise.

So Ethereum altering its consensus method is significant because:

• It will have an impact on scarcity which influences price.

• It changes the incentive structure for validating transactions.

• It might influence the cost of processing a transaction.

• It is fundamental to the security of the overall system.

• It impacts how scalable the system is.

• It will change its environmental impact

We can now examine the implications of Ethereum's strategy to transition to Proof of Stake at each phase.

The Merge - Issuance & Scarcity

One of the most serious objections leveled towards Ethereum in its current form is that, unlike Bitcoin, it has no supply limit. At the time of writing, Ethereum's annual emission rate (the rate at which new ETH are created through block rewards) is slightly less than 4%.

However, the actual rate of inflation is close to 0.5% due to the effects of EIP 1559, a change to the Ethereum function that went into effect in August 2021 and results in a percentage of transaction fees being burned. With fees burned, rewards reduced, and so many ETH frozen, Ethereum's inflation rate is predicted to be neutral, i.e., 0%, following the Merge.

This contributes to one of the most compelling arguments for cryptocurrency over fiat money: that it is a hedge against inflation since its supply is fixed and designed. Ethereum advocates see it as a step toward ultra-safe money.

Those who already own Ethereum will profit greatly from knowing that the value of their funds is not being undermined. It will also encourage more people to stake cash because the net benefit of the incentives would be bigger.

The Merge - The change to incentives

The transition to Proof of Stake fundamentally alters Ethereum's incentive structure for the critical task of a Validator - storing data, processing transactions, and creating new blocks. Rather than collecting rewards in proportion to the amount of energy produced, awards will be dispersed probabilistically based on the percentage of total ETH staked.

To be a stand-alone Validator, you need at least 32 ETH, which is out of most people's budgets, but you can instead join a staking pool. Joining a staking pool allows you to delegate your ETH to a validator and get proportionate rewards for proxy-securing the network.

Ethereum staking has been active since December 2020, with about 13 million ETH locked at the time of writing, valued at more than $13 billion. Staking has been earning a passive return of roughly 4%, however despite some assertions that this will climb to anywhere between 10-15% following the Merge, the official Ethereum site forecasts an increase of only 50%.

Staked funds cannot now be withdrawn, and this will be the case for some time after the Merge, maintaining the value of Ethereum by preventing Stakers from selling rewards instantly. This means that at present stake levels, approximately 11% of Ethereum's supply will be locked up until the Shanghai upgrade, which is planned 6-12 months after Merge.

The change in how blocks of transactions are validated following the Merge is also likely to hinder some of the dark arts of block reorganization, in which PoW miners try to extract profit by prioritizing or 'front running' transactions in a process known as MEV (Miner Extracted Value).

The Merge - Scalability

One of the most fundamental issues that The Merge seeks to address is Ethereum's scalability. The only method to process more transactions under PoW is to increase the size of a Node, which would centralize the network with powerful and expensive computers, or to increase the speed of block generation, which would modify the supply schedule and harm security. The solution is known as sharding.

Sharding will aim to spread out the network's needs by breaking one chain into up to 64 new chains. It may be contradictory to have significantly more chains if the goal is to lessen the pressure on Nodes, but Validators - who maintain the network - will only have to run one shard, not the entire network.

As a result, lighter-weight Validators should emerge, making it easier to become a Validator and making Ethereum more decentralized. However, before you get too enthusiastic, Sharding is not expected until 2023, and the Ethereum website states that it is a myth that transactions will be faster or cheaper.

Scaling improvements will take time and may be influenced more by the creativity of layer 2 applications and the availability of Sharding.

The Merge -- Proof of Stake & Environmental Impact

The switch to Proof of Stake is expected to reduce Ethereum's energy consumption by 99.95%. This is because, rather than a continuous obligation to spend electricity, the network will be safeguarded by the Ethereum staked by validators.

Though there is no clear data, Ethereum alludes to a Digiconomist report that compares current PoW energy consumption to that of the Netherlands.

The Bitcoin community has questioned Digiconomist's methodology and logic. However, it is undeniable that Ethereum will be 100x less energy-intensive after the merger. It is unclear whether this trade-off improves its security.

Electricity consumption is a value judgment. Many people use electricity to power Christmas lights, but Bitcoin uses electricity to support a censorship-resistant form of money because its advocates believe that Proof of Work is the only consensus process that provides true decentralisation.

Because Ethereum has switched to Proof of Stake, security is derived from users making a cash pledge. Some claim that this makes Ethereum more prone to collusion, especially as most staking is done through delegation to staking pools, which may be easily gamed.

The Merge -- Challenging Bitcoin

One of the most significant potential effects of the Ethereum merger is a bigger challenge to Bitcoin's dominance as the most important cryptocurrency.

All of the beneficial effects of Proof of Stake could combine to make Ethereum more investable, however this assumes:

• that there is no improvement to Bitcoin in the meantime

• that Ethereum‘s position isn’t challenged by other Layer 1 chains

• that the Merge actually achieves its aims

The debate between Ethereum and Bitcoin Maximalists will never be resolved, but people who are not involved in the debates that erupt on Discord and Twitter are likely to focus on the most visible change: the huge drop in Ethereum's energy use.

This will also play well with regulators and legislators who don't understand, or don't care to grasp, the complexities of Proof of Work's environmental impact.

When you combine the environmentally friendly message with better staking rewards and the ultra-sound money tag, Ethereum has some clear USPs that the ordinary Joe can grasp without getting bogged down in complexities.

As a reminder, WikiBit is ready to help you search the qualifications and reputation of projects in a bid to protect you from hidden dangers in this risky industry!