“The Merge,” Ethereum’s transition from proof-of-work (PoW) to proof-of-stake (PoS) is coming soon with a launch in Q2 of 2022.
While other protocols and products in cryptocurrency have been able to iterate and come out with new exciting features quickly, Ethereum has been steadfast and deliberate in its slow progress towards a sustainable and scalable architecture for their blockchain. But the transition from proof-of-work to proof-of-stake isn’t just for show. It provides a whole host of new bullish dynamics to understand and invest around:
- Predictability of block times
- Security of the network
- Supply/demand dynamics
- Energy efficiency
Also when the merge is complete, supply will become deflationary, implicitly meaning that ETH as an asset will be more valuable per token—there’s just less to go around. Overall, it’s nearly universally agreed to be a positive catalyst for the network.
But besides stacking ETH, what opportunities exist for retail users?
Today, we’re going to dive into that and more, equipping you with all the info for this revolutionary update to the so-called ‘world computer.’ And we’ll get into why the Merge makes us much more bullish than ever on Ethereum.
A note: In this report we assume that readers have a solid understanding of PoW and PoS. If you don’t understand PoW vs PoS, you can check out this link to learn more
Merge Basics: The Beacon Chain
The Ethereum merge is a hard fork that moves consensus on all blocks from the current PoW chain to the already running PoS layer called the “Beacon Chain.” Launched at the end of 2020, the Beacon Chain has been running in parallel to the Ethereum Mainnet with ~320k validators running nodes and more than 10M staked ETH (the number can be tracked here).
But why is this change even necessary? Well, the switch to PoS consensus in the Beacon Chain is a step closer towards the long-term Ethereum vision mentioned above, which focuses on:
- Security: Requires a minimum of 16,384 validator nodes, and will eventually be able to be run by PC-equivalent hardware
- Sustainability: PoS uses roughly 99% less energy than PoW consensus.
- Scalability: 64 ‘shard’ chains in the future and current scaling solutions will allow for up to 100,000 transactions per second on the Layer One network
The fundamental shift for the merge is a shift of the blockchain from proof-of-work, which uses miners to power the network, to proof-of-stake, in which validators who hold ETH run the chain. In exchange for running the network, they receive a percentage yield on their Ethereum. Miners get paid out now in ETH, after the merge it will be ETH stakers that get paid.
To become a validator for the Beacon Chain, users must deposit a minimum of 32 ETH (worth around $90k) on Launchpad, which prices out a large majority of retail users. Another obstacle to become a validator is liquidity: staked ETH, until the merge, cannot be sold.
These obstacles have created space for services like Lido and Rocket Pool to enter the market, where users who want to earn staking interest on their ETH but don’t want to lock up their coins can do so.
These protocols are pretty simple:
- Deposit ETH
- The protocol stakes the ETH to a validator for you
- You receive a liquid (sellable) wrapper representing a right to that staked ETH
- The staked ETH accrues interest
- You can use the liquid wrapper on various DeFi protocols across the Ethereum ecosystem to enhance yield
This website aggregates all of the different staking services.
How to Win the Merge as an Investor
Rocket Pool is currently our favorite option for staking ETH as it caters well to both small retail participants as well as people who want to run their own nodes.
- Rocket Pool for Investors: You can get Rocket Pool ETH (rETH) by staking ETH into Rocket Pool or buying it on the open market. Since rETH accrues interest from staking, the exchange rate for rETH to ETH is constantly increasing, so rETH gets more and more valuable relative to ETH. Accrued staking rewards aren’t paid out until rETH is redeemed. This provides a tax benefit for long term users and a simple way for staking rewards to accrue.
- Rocket Pool for Validators: Running a node through Rocket Pool is unique and more accessible than being a solo staker through Launchpad. Anyone can set up a node by depositing 16 ETH, which is coupled with 16 staked ETH (pooled deposits from non-validating stakers) to create a new validator called a minipool. Minipools are run by Rocket Pool smart contracts and thus completely decentralized.
Some reasons why we like Rocket Pool:
- Rocket Pool has 973 node operators (it’s quite decentralized)
- If a node operator is compromised, rETH liquid stakers are protected
Rocketscan is the explorer to see the distribution of validators, node operators, mini pools, rETH to ETH ratio and more.
The Runner Up: Lido
Lido, on the other hand, is a protocol for simple liquid staking deposits into stETH that has the same functions as rETH. One of the potential advantages Lido enjoys over Rocket Pool is the amount of ETH staked, which is north of 2.7M vs. Rocket Pools 150k.
Additionally, there are more DeFi apps that use stETH in their protocol that allow for more yield enhancing possibilities, although we believe this advantage will lessen over time as more apps adopt a variety of liquid ETH wrappers.
Lido works in a similar way, although rewards don’t accrue directly to the token as with RocketPool ETH. stETH effectively functions as a receipt for ETH in the future. The way stETH works:
- Put ETH into Lido
- Get stETH
- Lido stakes the ETH on your behalf
- You leave your stETH in the protocol and interest accrues in the form of more stETH tokens
- You can also wrap your stETH which makes it function in the same way as rETH
The Long Term Stackoooor
In a world of quick altcoin flips and exciting ways to lose your money (only half joking here), the tedious route of bi-weekly ETH purchases can seem rather cumbersome and un-sexy. But Ethereum is positioning itself to be the most efficient and secure blockchain solution for all use cases: hence, at Crypto Pragmatist, we want to stack as much ETH as possible in preparation. Earning yield on the asset is just a bonus. Sure, there is bigger upside in DeFi, but if you want a (relatively) safe option, ETH is the way to go.
This simple strategy can sometimes be overlooked, but setting up recurring buys on an exchange that allows you to withdraw directly to Layer Two solutions (Arbitrum is our favorite) will be the most cost effective way to continue to add to your ETH pile in a decentralized way. For this we like FTX, Crypto.com, and Binance.
Once on Arbitrum, any Dex (such as Uniswap), has liquidity to swap into rETH, which will have the same effect fee accrual wise as if you were staking on Rocket Pool directly. This is a simple way to both HODL and earn a yield at the same time.
How Will Ethereum Become Deflationary?
The EIP-1559 upgrade, also known as the London Fork, started to burn a portion of the transaction fees originally paid to miners. This created a small deflationary pressure for ETH.
Now, with the shift from PoW to PoS, the rewards paid out to validators will be reduced by roughly 90%. The ETH burned now will likely often be higher than the amount issued, reducing overall supply. Since the network requires less energy, less rewards are necessary to incentivize the network as well.
Keep in mind, however, that network activity will be the ultimate determinant for supply and gas prices.
Do I HAVE to Stake my Ethereum?
Staking is not required. But taking advantage of liquid wrappers, especially when more yield opportunities present themselves, is a great way to enjoy the security of the Ethereum network, help create a more decentralized and energy-efficient network, and earn passive yield.
How Does Validation Work?
Staking is done via validators, who are essentially the referees of the Ethereum ecosystem and watch for transactions/blocks being posted to the network. When things look good, they will attest that the proposal is valid by doing some computation and verification. Occasionally, validators will be randomly selected to propose their own block (this has plenty of implications into protecting the security of the network). In a bad actor/malicious event, the validators stake gets slashed.
What is Sharding?
At some point, the implementation of shard chains will expand even further on the use case and efficiency of the Ethereum ecosystem. They can be a bit of a technical headache, and if you are eager to dive into the subject Ethereum.org has plenty of resources on how things will work. The basic idea? Shards break up the Ethereum database for efficiency and speed improvements.
Unfortunately, shards are not planned to be shipped until 2023, which still could end up being optimistic. Regardless, the updates will be here eventually and bring a heap of benefits with it.
Sharding itself theoretically will not bring much reduction to the current mainnet transaction fees. The real benefit fee-wise from shard chains is when they are combined with Layer 2 solutions, or rollups.
The endgame for Ethereum is a combination of Layer 2 solutions and sharding. Computation will take place on rollups, with the ‘end state’ (transaction database) storing independent shard chains. All of the gas-heavy transactions and computations take place on cheaper layer two protocols.
Validators will only need to store and run data on their shard, not the entire network. This is what will allow for users to run a node on hardware akin to a Macbook.
After having a couple of months to cool off from the euphoric run of 2021, we have taken time to think about where crypto is headed in the long term. While there are still exciting innovations occurring across the entire blockchain and cryptocurrency world, Ethereum has cemented its place as the smart contract king.
The updates we have discussed above bring the potential to onboard the next hundred million users while maintaining the most important aspect of blockchains: decentralization. To place your bet on Ethereum, stacking and staking ETH and into the merge is a surefire way to benefit.