Merger Mania
Eth price +60%, merge is on, here is what is happening
On July 14, Tim Beiko of the Ethereum Foundation and unofficial merge timeline expert, suggested that the merge could occur the week of September 19 during an Ethereum consensus layer call. His comments were enough to send eth prices up 60% in two weeks.
On July 27, the Ethereum Foundation, announced that the final testnet Goerli will be transitioned to PoS between August 6-12. That is the last major step before the merge. The merge is rapidly approaching. Markets are awakening to it.
In this piece, I cover
Merge recap (A summary of what it is. And why it’s a big deal)
Merge 101 (What is actually going to happen)
Risks to the merge
Market dynamics
Merge Recap
The Ethereum blockchain is merging its main Proof of Work (“PoW”) blockchain, called “Mainnet,” with its Proof of Stake (“PoS”) blockchain, called “Beacon” chain. It is one of the most advanced live engineering feats attempted. The Ethereum blockchain will not have any downtime. Users will not experience any changes. It’s akin to swapping out the engine of a spaceship mid-launch. It’s undergone a year and a half of testing. It’s been years in the making and delayed several times.
In The Business Case for Ethereum, I explained how the merge dramatically changes the business case for Ethereum and why it is the most monumental event in crypto since the launch of Ethereum. In short, merging to PoS chain allows for:
Improved economics: Vastly lower token issuance, which makes the Ethereum network profitable.
Better environmentally: Energy intensive mining operations are not required in PoS. Ethereum’s energy usage will decline by 99%.
More secure network: It is costlier to mount a 51% attack to undermine the integrity of the blockchain.
Merge 101
Mainnet runs a PoW consensus mechanism to authenticate and execute transactions on the Ethereum blockchain. The Beacon chain runs PoS to reach consensus. There will be two layers to the Ethereum blockchain once the Mainnet and Beacon merge. Mainnet will be the execution layer where transactions are recorded. Beacon will be the consensus layer.
Validators need to run separate clients on the execution and validation layers. A “client” is software that allows validators to read and interact with blocks on the Ethereum blockchain. There are five different clients for the PoS consensus layer and four for the execution layer. Different clients are used for different programming languages. The Ethereum Foundation (“EF”), the group responsible for proposing and testing changes to the Ethereum blockchain, is ensuring that all clients can be used post merge. There are 20 permutations of different consensus and execution layer clients to use.
The Ethereum blockchain has test networks, called “testnets.” Testnets are used by EF and builders to test blockchain upgrades and applications respectively before launching them on Mainnet. Testnets have been used as dress rehearsals for the merge.
On June 8, Ethereum Ropsten Testnet was successfully merged with the Beacon chain. On July 6, Ethereum Sepolia Testnet was successfully merged. Goerli is the third and final testnet to be merged between August 6-12.
Ten of twenty shadow forks have been successfully completed. Shadow forks are private test hard forks meant to mimic what an actual hard fork will look like. A hard fork occurs when a blockchain splits, like a fork in the road. One path has the new blocks that continue to form the blockchain. The other path usually ends. The merge can occur after the remaining shadow forks have been completed and the successful Goerli merger.
The first step to merge is hard forking the Beacon chain. The Beacon hard fork is named Bellatrix. As part of the Bellatrix fork, an upgrade is introduced to allow old blocks initiated on Mainnet to be absorbed. The Bellatrix upgrade ensures the old transactions on Mainnet are preserved.
Step two is reaching a predetermined, yet to be communicated, Terminal Total Difficulty (“TTD”) number. TTD is a cumulative measure of total mining difficulty on Mainnet. Once the threshold is reached, the third step is initiated.
Step three is a hard fork of Mainnet called Paris. The Paris hard fork includes upgrades to prepare Mainnet to merge with the Beacon chain. The main upgrade removes the dependence of PoW and introduces new dependency on the Beacon chain’s PoS consensus mechanism. The upgrades get automatically implemented once the TTD number is reached.
At that point, the two chains will merge. From one block to the next, Ethereum will go from PoW to PoS. There will be zero downtime. Users will not experience any material changes.
Risk at the merge
The merge is the highest profile consequential blockchain transformation in history. Users, myself included, have a lot of faith in EF to successfully execute the merge. In the event of a catastrophic collapse, I believe the community will coordinate a block reversal like it did with the DAO hack. It won’t be the end of the Ethereum blockchain. However, Eth price will get decimated. Developers may shift to other Layer 1 chains.
I believe the risk of a catastrophic collapse at the merge is low. I have been building a large eth position in advance of the merge. I believe the two main areas of risk at the time of the merge are:
1. User error
The merge is more complex than my simplified explanation. There are multiple stages that require different activations all while Ethereum continues to execute 1.2 million transactions per day. If too many validators fail to upgrade the network will grind to a halt.
2. Client failure
Functioning clients are critical to the merge. They have been rigorously tested. However, if not all clients work the network performance will deteriorate and client diversity will become a larger risk.
Risk post merge
Once the merge is successfully executed, there remain two main risks that could impact the Ethereum blockchain.
1. Client diversity
Client diversity refers to the number of different types of clients used by validators. The greater the diversity, the better. Prysm is the largest with 41% market share down from 66%. The goal is not to have a client with more than 33% share. If a client has over 50% and validators using that client collude, they can affect finality. A block has “finality” once it is validated and cannot be changed. In this scenario, colluders could enact a transaction to their economic benefit. Overturning said transaction would be doable but difficult with a 51% control and nearly impossible with 66% control.
As long as a client doesn’t have over 50%, diversity is a low risk.
2. Design issues
A design flaw of PoS is that every block proposer is known in advance. An attacker could monitor validators and their associated IP address. When it’s time for the validator to propose a block, the attacker could launch a distributed denial-of-service (“DDoS”) attack. DDoS is a malicious attempt to disrupt a targeted IP address by flooding it with internet traffic. A DDoS would hamper new block creation. It would create severe disruptions to the Ethereum blockchain.
Validators could DDoS other validators. By attacking the prior validator, the culprit could steal the attacked validators fees.
This risk is manageable because larger validators already have infrastructure to prevent DDoS attacks. Eventually, an upgrade will be executed to hide who the next block proposer is.
Market reaction
Eth price is up nearly 60% since the news and is outperforming most notable protocols.
An eth short squeeze is also propelling eth prices up. FTX and maybe others bought large amounts of illiquid heavily discounted stETH from imploding CeFi platforms. (In Freezing Celsius, I covered Celsius’ large stETH position and why it would lead to their bankruptcy.) FTX hedged its eth exposure by shorting eth. FTX is rumored to have sold stETH piecemeal to other entities. It then covered its eth short. Covering a short requires buying back eth. FTX profited by the difference between the prices it sold stETH piecemeal and its hedged eth price. Hedging eth price by shorting it meant FTX took no eth price risk.
Is the merge priced in?
Vitalik doesn’t think so.
“I expect that the merge is not going to be priced in, by which I mean not just in market terms, but in psychological and narrative terms.” - Vitalik Buterin on Bankeless July 27, 2022.
Recently no one cared about the merge. Global markets sold off from a changing macro outlook. Crypto was crashing from poor macro exacerbated by a crypto deleveraging and a slew of self-inflicted implosions (read CeFi Casualties) . The baby was getting thrown out with the bathwater.
In a recent podcast episode I did, called The Path To Profitable and Sustainable Blockchains I outlined my valuation for eth. Think of eth as a 5% dividend yield + 1% earnings yield + 1% share buyback. A 7% yield, or 14x earnings, is attractive for a potentially breakthrough technology with arguably the largest total addressable market in the world. Google historically trades at 30x earnings.
The merge gets Ethereum 40% of the way through its development roadmap. Today, Ethereum can process 10 transactions per second. It has a road map to get to 10 million transactions per second, through a combination of amusingly named upgrades.
Ethereum’s roadmap and valuation will be topics of future posts. Stay tuned!