What the Ethereum Merger Means for Blockchain Projects and Investors.

 

The Ethereum "Merge" narrative has taken over crypto, with ETH rallying more than 50% since the highly-anticipated Merge to Proof-of-Stake date was announced for September 15. Traders worldwide are bullish on ETH as they anticipate Ethereum to gain momentum once the update happens.

It begs the question, why is this upgrade a big deal, what will happen after the Merge, what does it mean for Web3 projects, and what do Ethereum competitors think of the Merge?

Let's dive in.

1. What is the Ethereum Merge, and why is it happening?

The Ethereum Merge is probably best described as a large-scale shift in the network's consensus mechanism and is the most significant upgrade in the history of Ethereum.

Ethereum Mainnet utilizes a system where miners use energy-intensive computing power to reach consensus and secure the network. While proof-of-work has played a crucial role in distributing ownership of ETH tokens and decentralizing the web, like other proof-of-work blockchains, it has been criticized for its lack of scalability and sustainability.

On the other hand, the proof-of-stake system utilizes a consensus mechanism achieved through economic incentives. The network's security depends on validators staking – or locking up – their ETH tokens. By removing the need for energy-intensive hash power, proof-of-stake has made blockchain networks like Avalanche more scalable and sustainable than proof-of-work blockchains.

Ethereum's proof-of-stake system, the Beacon Chain, has been running as a parallel blockchain since December 2020, undergoing multiple tests in the last two years. The Merge, expected to occur in mid-September, represents these two systems finally coming together, with Ethereum's proof-of-work system permanently replaced by the proof-of-stake system. The entire transactional history from the main net will move to the Beacon Chain, which will become the consensus engine for all network data – including execution layer transactions and account balances.

1. What will actually happen after the Merge?

Decrease in issuance rate & deflationary pressure: Perhaps the most immediate impact post Merge is the significant decrease in the issuance rate of the ETH token. With the proof-of-work system ceasing, the Ethereum network will no longer issue ETH token rewards to miners – a change estimated to drive a ~90% reduction in ETH's annual issuance rate. This drastic reduction in the issuance rate, combined with the fee-burning mechanism introduced by the EIP-1559 proposal, will likely result in the Ethereum network turning deflationary during periods of elevated block space demand. This represents a fundamental, structural change to the Ethereum Network on a scale that is unprecedented in its history.

Source: https://ethereum.org/en/upgrades/merge/

Network capacity remains unchanged: It is important to note that the Merge itself will not directly expand the capacity or throughput of the network itself, with the introduction of subsequent sharding updates intended to address the long-term scalability issues of Ethereum. This means that block space remains unchanged, and gas fees will continue to be driven by demand for block space, with Layer2 rollups providing the much-needed scalability for users.

Increased block space demand & potential rise in gas fees: Gas fees may even increase with elevated network demand post-Merge. Staking rewards will increase from what is currently rewarded on the Beacon Chain, as transaction fees that used to be paid to miners are now paid to validators. With increased staking rewards, ETH may become a much more attractive asset, driving increased institutional interest in the asset and network.

1. What does this mean for L2s and apps built on Ethereum?

L2 season: The increased interest in the Ethereum network post Merge is expected to drive up block space demand and gas fees, placing greater importance and demand on Layer 2 scaling solutions such as Starkware, Polygon, Arbitrum, and Optimism. Dapps built on Ethereum Mainnet will continue to migrate to Layer 2s if they have not done so already, as liquidity mining incentives, lower gas fees, and potential retroactive token airdrops drive users to migrate their assets off Mainnet over to L2s.

Improved onboarding and UX requirements: As users accrue on these rollups and TVL grows, new protocols will also be incentivized to be built directly on L2s, placing a greater need for UX improvements across on-ramps, wallets, and bridges to better onboard users now onto L2s.

Liquid staking providers to benefit: The increase in ETH staking yields will directly help to stake protocols such as Lido and take. Retail and institutional token holders seeking liquidity on their staked ETH will increasingly migrate to liquid staking providers.

1. What does this mean for crypto investors?

Structural supply-side changes likely to have a positive impact on price: The structural changes to ETH's token supply – made possible by EIP-1559 and the Merge — have been highly anticipated by the crypto community for some time. Eliminating ETH mining rewards decreases the issuance rate but also helps reduce selling pressure from miners selling their ETH to cover operational costs. As a large amount of ETH gets staked to validate the network, a large portion of ETH will also be removed from the circulating supply, significantly reducing the amount of circulating ETH available for retail and institutional investors to buy on the market.

Staking yields and ESG narrative to drive increased institutional adoption: The transition from an energy-intensive proof-of-work consensus to a sustainable, energy-efficient proof-of-stake consensus helps Ethereum avoid the negative ESG narrative that has prevented many institutional investors from allocating their funds into major crypto-assets like Bitcoin or Ethereum. At the same time, the increase in staking yields will make ETH a more attractive passive asset, likely driving increased institutional interest in the investment.

1. What do Ethereum competitors think of the Merge?

While the stakes are massive for Ethereum, rival projects that offer faster and cheaper transactions, like Solana and Avalanche, are watching closely and benefiting from the buzz around the Merge. Should the Merge be successful, it may help Ethereum extend its lead over its rivals in the L1 race. On the flip side, it could boost the visibility and growth of all Layer 1 platforms. In a recent story in Fortune, leaders from the two Ethereum rivals mentioned above shared their thoughts on what the Merge means for their projects:

• Anatoly Yakovenko, Solana — "The Merge is long overdue. All the networks launched over the last three years have been using proof-of-stake. The only impact that I see is that the industry can finally, as a whole, point to the blockchain as an energy-efficient way to build Web3. For folks not deep in the technical details, it will finally be obvious proof-of-stake is as secure as proof-of-work but much more energy-efficient."

• John Wu, Avalanche — "You have all the variations of 'Layer 1s' that will be around for various purposes because their communities and technologies all have slight differences. It's pretty hard in today's world to be good at everything, regardless of Web2 or Web3. Avalanche, obviously, [and also] the 'Layer 2s' out there, definitely benefit from Ethereum growing. There is a symbiotic relationship."

It is worth mentioning that even if the Merge goes perfectly to plan, Ethereum still has a long way to go before it achieves the speed and efficiency that its proponent claim is possible. But given the resilience of the Ethereum ecosystem and its massive community, it would be hard to bet against them. Expect the Merge to dominate crypto narratives until September. What happens afterward is anybody's guess.