The Ethereum upgrade, widely known as ‘Ethereum 2.0’, has been in development for years to improve the sustainability, scalability, security and economics of Ethereum 1.0, which was launched in 2015.
Since its launch, Ethereum 1.0 unleashed innovation in smart contract applications, stablecoins, decentralized finance (DeFi), non-fungible tokens (NFTs) and more.
Ethereum is home to the largest DeFi ecosystem compared to other chains with over $154 billion in stablecoins, $72 billion in capital committed (total value locked) and $620B+ in decentralized exchange volume in 2021
4,000 developers, the most among layer-1 blockchains
$13.6 billion in NFT trading volume in 2021
The above examples are just some reasons why ETH’s market value is now second to only Bitcoin, rising from $42 million in August of 2015 to more than $237 billion today. While the growth of Ethereum has been staggering; scale, capacity and energy consumption are common criticisms of Ethereum 1.0 and are the issues Ethereum 2.0 is designed to address.
The two primary improvements that will be introduced by Ethereum 2.0 are: (i) a move to a Proof-of-Stake (PoS) consensus model (“The Merge”); and (ii) the introduction of shard chains. While both upgrades are technically part of Ethereum 2.0, these upgrades will occur in two phases. Phase 1 will move Ethereum to PoS and is expected to go live in Q3 2022. Phase 2 will introduce sharding, materially increasing the scalability of Ethereum, and is expected to be live in 2023.
Currently, Ethereum 1.0 runs on a consensus model called Proof-of-Work (PoW). Miners – individuals and firms that perpetuate the blockchain – expend electricity (work) to earn the privilege of creating a new ‘block’ on the blockchain and are compensated in the form of ether, the native currency for Ethereum, for doing so. The first miner to solve the problem produces the next block by validating all pending transactions and appending the block to the blockchain.
Miners build consensus around the longest chain, which is the chain that required the most electricity and computing power to create. This ensures the blockchain is secure and hard to compromise, as doing so would require more computing power than the rest of the network combined in order to be able to produce the longest blockchain.
Ethereum 2.0 will move to a Proof-of-Stake (PoS) consensus model. This model is different from the PoW model in that validators (as opposed to miners) are responsible to produce the next block. A validator is any entity that commits (stakes) 32 ETH (a ~$80,000 value as of May 10, 2022) to the network. Instead of miners competing to produce the next block by solving the computationally intensive math problem described above, a random process will select a validator to produce the next block.
Moving the PoW model to PoS provides significant benefits that are discussed further below:
Less power consumption (sustainability)
Lower transaction costs (scalability)
Additional security (security)
Improved economics of ETH
It is estimated that Ethereum currently consumes about 0.5% of global electricity consumption per year – about the same amount of electricity as the country of Sweden (104TWh). Once Ethereum moves to PoS, the electricity consumption is estimated to fall by 99.5%. Because PoS removes the need for miners to solve a computationally intense math problem, it is expected to be substantially more energy efficient.
The current transaction fee to use Ethereum is $0.91 per transaction, and varies by demand (in 2021, fees rose to $75 per transaction during a period of high congestion). While $0.91 may seem low, it is likely prohibitive for applications that involve many small transactions per day.
A driver of the transaction fee at any given time is, in part, the energy costs incurred by miners. Therefore, as PoS reduces the electricity cost by more than 99%, miners will require less in the way of compensation for validating transactions. We believe lower energy consumption will lead to cost savings for users over the medium-to-long term.
At scale, we believe PoS will prove to be more secure than PoW. To hack a PoW blockchain, a bad actor must temporarily control 51% of the computing power of the network – conceivable, albeit extremely difficult and expensive.
By way of comparison, we estimate it would cost $6.5 billion in hardware alone to hack PoW Ethereum, without taking into account additional energy resources. We believe that a PoS blockchain with sufficient scale is even more secure.
To hack Ethereum 2.0, a hacker would need to acquire 66% of the stake to successfully double spend assets (enough to finalize a transaction). Acquiring 66% of staked Ethereum will be practically impossible as this would likely require buying about 50% of all of ETH (if 70% of ETH is staked) - worth about $137 billion at today’s value. This sum is substantially higher than acquiring 51% of the computational power of Ethereum 1.0.
The move to PoS will improve the investment case of owning ETH by making it a yield generating asset and slowing its issuance
Ethereum’s move to PoS will move the responsibility of securing and validating the chain to owners of ETH as opposed to miners, resulting in a more productive yield generating asset for a broader subset of users. Anyone who holds 32 ETH will be able to become a validator, stake their Ethereum and start accruing staking rewards. For those who own less than 32 ETH or prefer to avoid the technical requirements of staking, professionally managed staking pools will accumulate ETH, validate the Ethereum blockchain and distribute staking rewards back to owners.
The actual amount of yield accrued by stakers will vary. Currently, there are about 12.5 million staked ETH in the pre-launch staking contract, which yields ~5%. However, once PoS is live, we expect staked ETH to approach 70-80m (~60-70% outstanding ETH) over the next number of years and the associated yield will be 1-2%, as per Figure 1 below. Simply put, we believe that the yield on staked ETH will start at 5% and converge to 1-2% over a number of years as more ETH is staked.
Figure 1. Bonding curve for yield accrued by stakers
Source: Chart by Domain Money using data from: https://twitter.com/vitalikbuterin/status/1326444925957754880?lang=en
Another important aspect of the move to PoS is that ETH issuance will decline dramatically. Currently, 2 ETH are rewarded to miners per block, resulting in approximately 6.4 million ETH in new issuance each year, given that blocks are produced every 14 seconds.
In Ethereum 2.0, issuance is expected to follow the curve in Figure 1. If we assume that 12.5 million ETH are staked, ~600,000 ETH will be issued and distributed per year. When we approach the expected terminal staking participation of about 70-80 million ETH, the issuance will be between 1-2 million ETH per year. In any scenario, Ethereum 2.0 will lead to 70-90% less Ethereum issuance than Ethereum 1.0, resulting in significantly less ETH inflation. We believe the scarcity should create more support for ETH’s price.
As an analogue, take the concept of bitcoin “halving” events, which is when the block reward for bitcoin is cut in half. These halving events have generally led to periods of price appreciation as the issuance of bitcoin is reduced.
By our estimate in the figures laid out above, the Ethereum 2.0 merge is equivalent to about 2-3 bitcoin halvings due to the substantial reduction in Ethereum issuance. While there is obviously no guarantee that Ethereum will appreciate because of the reduction in issuance, if Bitcoin is any guide, the supply decrease should put positive market pressure on the price of ETH by reducing the growth of supply. After the 2016 and 2020 halvings, Bitcoin’s average 6 month return was ~50%.
While the move to PoS has many benefits, our view is that alone it will not materially impact scalability. PoS does not change the abundance of blockspace, and therefore, we do not see it making transactions cheaper in the short run. We are, however, optimistic that sharding will provide the needed improvements to increase the scale of Ethereum.
Sharding is the concept of splitting a database into multiple pieces. The current Ethereum 1.0 blockchain is a single chain of blocks that holds all data for the Ethereum network. The goal for Ethereum 2.0 is to allow for multiple (64) independent shards each with their own validators.
By dividing Ethereum into 64 shards, Ethereum will be able to scale the number of transactions per second as they are processed on separate chains in parallel. Currently, Ethereum can process 13 transactions per second, and therefore, it is conceivable that after sharding is implemented, Ethereum’s capacity will rise to about 1000 transactions per second.
While this model has the opportunity to greatly increase the scale of Ethereum, there is still significant engineering to be done by the Ethereum Foundation to be able to realize this vision. We expect Phase 2 of Ethereum 2.0 will likely be released in 2023.
Figure 2. Visual representation of sharded Ethereum
Though these changes are notable, and support part of our investment case, risks exist. Technical aspects of the merge have been delayed more than once, and could continue. Further delays could sour investor and community expectations, which rose considerably as the original merge date timeline approached.
In its first 7 years of existence, Ethereum went from a proof-of-concept to becoming the most valuable smart contract platform in the world.
The combination of these features in ETH 2.0 – first with PoS and then with Sharding – will make Ethereum more scalable, secure, sustainable and also improve the investment case for holding ETH.
After watching Ethereum 2.0 debated and developed over the last number of years, we are excited to see Ethereum 2.0 come to life.
* Important disclosures: Market pricing information is sourced from Yahoo! Finance, Ycharts, nonfungible.com, theblockcrypto.com, duneanalytics, NonFungible Yearly NFT Market Report 2021, ethhub
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*** As of the time of this writing, Domain Money Advisors, LLC clients are invested in: BTC, ETH