The much anticipated Ethereum merge is just a few days out, causing waves of interest and excitement far beyond the web3 industry (see here, here or here). This week I (Abigail Carlson, marketing manager at MESH) sat down with Patrick Li and Robert Drost of the MESH team and Praneeth Srikanti of Ethereal Ventures to ask them some informal questions about how the merge will affect the industry. See what they had to say below.
Q: It would seem that a lot of misconceptions around the merge are circulating. What are some of the biggest misconceptions you’ve seen?
PL: One of the biggest misconceptions I have seen is that some people think the merge will reduce gas fees. According to the Ethereum Foundation, "gas fees are a product of network demand relative to the network's capacity. The merge deprecates the use of proof-of-work, transitioning to proof-of-stake for consensus, but does not significantly change any parameters that directly influence network capacity or throughput." Gas fees will eventually be reduced after the merge through sharding, which would split the network into smaller pieces and distribute data settlement more efficiently. The transition to sharding is known as Surge, which is expected to happen in 2023.
RD: Good point, Patrick, on the gas fees as the biggest misconception – I fully agree with that one. There’s a nuance though that gives hope to near-term scaling of L1 mainnet! The Ethereum Foundation and larger Eth researcher community have worked on a few shorter term data scaling additions that will likely free up network capacity. EIP 4844 and EIP 4488 are proposals that are being considered for quick addition, potentially as soon as the first network upgrade post-merge. Either would dramatically increase the data space on Ethereum for rollups and bring down layer 2 transaction costs. While this would help overall by making transactions much cheaper on rollups, it would also help motivate more people to move assets and transactions off mainnet to L2s like Optimism and Arbitrum. That would in turn free up space on mainnet, and should lower gas prices on L1 for the rest of us by a bit (or maybe a lot :)) too!
Another misconception, or maybe more of a blindspot, of the merge, is not noticing the truly and utterly dramatic level of security increase that it yields! Before the merge and at current crypto prices, attacking Ethereum PoW to defeat its immutable and reverse out transactions via a 51% mining attack would cost on the order of $900,000/hour (the hourly mining reward for Ethereum). For comparison, attacking Bitcoin is on a similar order, about $750,000/hour at current crypto prices. This can matter in reality because if there are enough crypto transfers and Defi transactions settling that are worth reversing (for say a double spend attack), then it could make an attack worth doing. Attacks like this have certainly been attempted on other smaller PoW chains out there, and it’s why conservative financial institutions can wait so many blocks and hours (or even days!) to confirm larger (and even grander) transactions.
Proof of stake (PoS) introduces a radically improved system for security by adding “slashing” as an entirely new penalty mechanism for validators that attempt to attack the chain and reverse out transactions. In fact, 1/3rd of the staked ETH would have to be burned (and hence be permanently stripped and deleted from the attacker) in order to reverse a transaction under PoS. Currently, there’s about 13 million ETH staked or about $22B at current prices of around $1,700. So reversing a transaction after the merge would cost the attacker $7.3 billion!!! I don’t casually say hyperbolic things like “utterly dramatic”, but it seems appropriate in this case when you're increasing security protection from under a million to up to many billions of dollars! 1000 times+ type improvements are usually few and far between. And this security story gets even better when withdrawals of validator stake are enabled in a near-term upgrade after the merge. At that point, I anticipate we’ll go from around 10% of ETH being staked to well over 50%, hopefully with a well-decentralized body of validating stakers both outside and inside of staking pools, meaning the security level is likely to get up to well over $30B even at current ETH prices. So while most people focus on the environmental benefits of PoS vs. PoW (which is, of course, amazing too!) or the scaling improvements for transactions per second (which will eventually go up as Ethereum completes the data sharding roadmap upgrades), to me the arguably largest factor missed by many regarding the merge and PoS is actually the amazing security benefits it yields.
Q: How do you think the merge is going to affect crypto markets?
PL: Firstly, the ETH annual supply rate will likely decrease from ~4.3% to 0.43% after the merge, and nominal staking yield will increase from ~4.2% to 8.5-11.5%. This really makes holding and staking ETH an attractive return for institutional investors, so we can expect further institutional adoption. Secondly, the PoS chain will reduce the energy consumption by 99.95%. This will set a high ESG standard for other existing and emerging L1 chains in the crypto world. Last but not least, the merge is a prerequisite for the upcoming Surge, which will eventually help Ethereum to address the blockchain’s trilemma: decentralization, scalability and security. Once the trilemma is addressed, we can expect further and quicker growth of the Ethereum ecosystem.
RD: You can probably sum it up in one word: volatility. While it’s certainly within the realm of possibilities that the merge happens and ETH and other crypto prices just prod along uneventfully, it seems much more likely that there may be some unexpected and possibly wild price moves, especially if there are any last minute (or first minute) technical glitches. It’s probably a good idea that some exchanges and financial institutions are being a bit cautious about connecting to mainnet around the merge and are implementing pauses and monitoring for any issues.
PS: Some of the most interesting outcomes from the merge are the broader environmental impact that validators securing Ethereum now have, as well as the change of the security model of Ethereum to a more intrinsic one, leading to a much larger reduction in the correlation of ETH to other asset classes.
Q: Let’s talk about the possibility of a miner-led hardfork. Leaving speculation out of the equation, what would be the potential effects of this?
PL: A miner-led hardfork is unavoidable at this point and multiple CEXs have announced potential listings of hardfork ETHW tokens. This will lead to a potential ETH accumulation before the merge so more ETHW token airdrops can be expected. This has incubated several arbitrage trading ideas like (1) borrowing ETH on Aave before the merge, and (2) draining out an ETH related LP pool on PoW chain to get ETHW. So in a nutshell, the speculation of a hardfork is all on the potential value of ETHW tokens, and this is likely to be a short-term trade/speculation instead of a long-lasting ETH PoW ecosystem.
RD: Leaving speculation aside, the PoW hardfork is likely to be tried out. Existing miners with ETH hashing rigs have little to lose and a lot to gain if the ETHW proof of work token holds value. Something like an ETHW fork could become an ongoing fixture alongside well known ones like Eth Classic. But as all the major DeFi protocols have committed to backing their value only on ETH 2.0, it’s likely that there would be a lot of volatility as people cash out on any value of the ETHW token. It will definitely be interesting to watch! Longer term, one popular train of thought is that the proof of work chain would quickly lose users and attention. In this scenario, a PoW fork would end up with only a small fraction of ETH 2.0’s utility or value. Another scenario, though less likely, would be that some users would prefer the more anonymous crypto economic security mechanism of proof of work consensus over proof of stake. Due to the Tornado cash OFAC action, there has been concern within the Ethereum community over block proposers and validators risking sanctions on a proof of stake chain.
PS: Miner led networks do have the potential for easy incentives and speculative upside to offer to users with little/no issue around miner deployments - but this seems to reflect a short-term outlook for this network. It will be challenging for miners to attract more protocol developers and applications to adopt this for new app deployments and continue seeing sustainable network growth and maintenance. A less likely scenario that we see unfolding is the utilization of the PoW consensus to secure additional onchain middleware services via merge-mining techniques but this requires closer collaboration with the Ethereum community.
Q: After the merge, Ethereum will be 55% complete. What’s the next big thing the Ethereum community will set their eyes on post-merge?
PL: People might worry about a potential staked ETH dump after the merge, but the merge won’t directly unlock staked ETH as stakers will need to wait 6-12 months to unlock it, so it’s unlikely there will be a large selling pressure in the market. The next big thing after the merge will be Surge, where sharding will be introduced. That will be where the real fun starts as Ethereum can have serious scalability potentials then.
RD: The next major things on the roadmap will be some ordering of beacon chain withdrawals, either (or both) EIP-4844 and EIP-4488 for additional rollup data commits to Ethereum (lowering the cost of layer 2 rollup transactions), and a focus on building out the provider builder separation protocols around MEV systems like Flashbots. There’s also been a resurgence of attention to censorship issues around US regulations. The US-based OFAC regulator action against the current Tornado Cash anonymity set kicked off this attention. Both MEV and regulation induced censoring play in the transaction ingress and block construction part of Ethereum, so we’re likely to see active work and possible upgrades around that part of the protocol in the near term.
Q: What is important for institutional investors to know during this period in time?
PL: For institutional investors, it’s better to be aware of potential risks during the merge, for example, replay attacks. A replay attack is when someone copies your approved transaction data on one of the forked chains to the other chain to replay (repeat) it. This is possible because both chains are from the same source. Another risk will be liquidity squeeze in DEX protocols as some investors might be eager to drain ETH from the pool, so for some DeFi oriented institutional investors it will be better to withdraw LP before the merge.
PS: The merge will transform Ethereum into a powerful underlying infra layer supporting rollups/execution shards. PoS allows for the creation of validator committees as a primitive (making it easier for smaller block sizes, easier decentralized validation and a more efficient data-availability solution for rollup transaction data). This makes it harder to fork and there is capability for finalized state in a single-slot (compared to PoW, which is probabilistic) - making Ethereum an efficient settlement layer & the core infra for powering a lot more apps built (zk rollups, enshrined rollups and execution, minimized trust assumptions, PBS).
On the returns side, staking will start to form the basis for the risk-free rate for the broader crypto-ecosystem, thereby unlocking a whole world of financial products for investors with different risk appetites to get exposure to - and could form the basis for a larger quantum of capital inflows.
Robert Drost is the head of R&D at MESH. He holds his Ph.D. EECS from Stanford and brings experience leading R&D in large Silicon Valley tech companies. He is a multiple X startups Founder and CxO and brings an extensive array of expertise to Mesh’s R&D strategy and projects.
Patrick Li is a research analyst at MESH, where he mainly covers various research initiatives related to internal treasury management and ad-hoc analysis for portfolio companies and secondary markets. He has over 6 years of experience trading fixed income instruments in investment banking and pension funds.
Praneeth Srikanti is an investment partner and co-Founder of Ethereal Ventures. He has a background in enterprise networking at Microsoft and Oracle and has worked on investment teams of European and US VCs. He obtained his MBA from ESADE and the Chicago Booth School of Business, and is a CS graduate from IIT Bombay.
Note that the opinion reflected in this article are proprietary to those sharing them and do not reflect an official MESH stance on the Merge.
