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Ethereum Merge: What Happened & the Long-term Implications

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September 26, 2022
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    Ethereum provides much of the infrastructure underlying everything from decentralized finance (DeFi) protocols to non-fungible tokens (NFTs). So, the blockchain's shift from the Mainnet's proof-of-work consensus mechanism to the Beacon Chain's proof-of-stake algorithm was a monumental undertaking and a pivotal moment for the industry.

    Let's take a closer look at the Ethereum Merge and what's next for the world's second most popular blockchain.

    The Ethereum Merge has been in the works since late 2020 and represents a monumental achievement for the crypto ecosystem.

    What is the Ethereum Merge?

    The Ethereum Mainnet used a proof-of-work algorithm based on the pioneering work of Bitcoin creator Satoshi Nakamoto. In December 2020, Ethereum developers launched the Beacon Chain parallel to the Mainnet. Rather than validating blocks with energy-intensive mining, the new blockchain uses a proof-of-stake approach.

    Ethereum Merge
    Image courtesy of Ethereum.org.

    The proof-of-stake consensus mechanism involves validators explicitly staking capital in the form of 32 ETH into a smart contract on Ethereum. The staked ETH acts as disposable collateral to defend against dishonest or lazy validators. In fact, the economic penalties for misbehavior are exponentially higher than a proof-of-work system.

    The Ethereum Merge immediately reduced the blockchain's power consumption by 99.95%, fulfilling one of its key goals of becoming more sustainable. At the same time, the Merge brought the blockchain closer to achieving the scale, security, and sustainability it hoped to fulfill (more on this below in the following sections).

    What to Expect from the Merge

    The Merge did not significantly impact Ethereum holders. You don't have to do anything with your funds or wallet after the Merge. However, staking node operators, non-validating node operators, and smart contract developers may have to make some changes.

    After the Merge, ETH staking yields began to increase to reflect the transaction fees paid to miners under the old mechanism. While staked ETH (ETH2) will not be transferable until after the protocol upgrade completes in 2023, Coinbase and other exchanges introduced new tokens that let their users unlock the value of staked ETH.

    While Ethereum's energy consumption immediately fell, Ethereum users won't experience faster transaction speeds or reduced gas fees until other upgrades go live. The good news is that these benefits could start appearing next year with the Shanghai upgrade and other efforts that are already well underway.

    The Shanghai upgrade will change the Ethereum Virtual Machine (EVM) format and Beacon Chain withdrawals and reduce L2 fees. These updates will help on-chain validators, enable ETH2 holders to withdraw their tokens, and effectively lower the blockchain’s notoriously high gas fees. As a result, it’s almost as widely anticipated as the Merge.

    Potential Merge Implications

    The Ethereum Merge may not significantly impact holders, but that doesn't mean there aren't substantial ramifications.

    The Ethereum community remains divided on the long-term impact of the Merge. Opponents believe the Beacon Chain will increase centralization by enabling whales to control validation. However, supporters counter that the 32 ETH minimum to become a validator is a lower barrier than the investment in mining equipment.

    From a regulatory standpoint, the transition from proof-of-work to proof-of-stake could also have enormous implications. For example, there's a distinct possibility that the change could lead to Ethereum becoming a "security" rather than a "commodity" under the Howey test. If that's true, it could come under greater scrutiny from the SEC.

    The pro-security argument is that the change requires that validators have a sum of money they invest with a controlling organization to generate a profit from other participants. However, one could also argue that the decentralized nature of the network means there's no controlling organization and no validation pools at the protocol level.

    Regardless of how the SEC treats Ethereum, the IRS treats this cryptocurrency – and all cryptocurrencies – as property. This means they’re subject to capital gains taxes or ordinary income taxes upon sale or transfer. For example, if you buy ETH at $1,000 and sell for $1,200, you will owe capital gains tax on the $200 increase in value.

    What's Next After the Merge?

    The Ethereum Merge represents the first of many steps to reduce energy consumption, network congestion, and disk space requirements. To solve this blockchain trilemma, the organization transitioned to a proof-of-stake blockchain that will eventually use sharding to reduce data storage requirements and maximize rollup efficiency.

    Sharding upgrades will spread the data storage requirements across the entire network, eliminating the need for every node to hold 100% of the data. As a result, anyone could run a node from their personal laptop or phone. Ethereum anticipates that sharding will ship sometime in 2023, depending on how quickly work progresses after the Merge.

    In addition to increasing the number of nodes, sharding paves the way for more efficient Layer 2 solutions. These "rollup" solutions bundle transactions into a single transaction off-chain, reducing the data requirements. Combined with sharding, Ethereum anticipates achieving 100,000 transactions per second in the future.

    The Bottom Line

    Ethereum provides the foundation for everything from decentralized finance (DeFi) protocols to non-fungible tokens (NFTs). Unfortunately, high transaction fees, poor availability, and computational intensity have become significant challenges. The Merge is the first step in resolving these challenges by moving to the Beacon Chain.

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