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Writer's pictureDecasonic

Why Does the Merge Matter?

Updated: Dec 20, 2023

By Paul Hsu, Founder and CEO, Decasonic

Alejandro Ballesteros, Venture Investor, Decasonic

Cami Darling, Marketing and Community Manager, Decasonic


Today, September 14, 2022, is a moment in blockchain history. Years in the making, the long awaited Ethereum Merge is finally here. Big kudos to all the core developers and community members who have contributed to this innovation. We applaud your hard work and dedication to this innovation.


We are honored that Team Decasonic is actively investing and co-building during this moment in time for blockchain. We respect both the innovation that went into this milestone but also the lasting impact this has on the overall blockchain, web3 and metaverse ecosystem. The future is bright for mainstream adoption.


We wanted to share some perspectives on this milestone:


  1. First, with some perspectives on the technical innovations from the Merge,

  2. but also some hot takes on the winners and losers from this event.


Organized in two sections, feel free to scroll forward to section two if you want to review those specific headwinds and tailwinds from this technology.


What are the technical innovations with the Merge?


First, some background on the technical innovations, led by the detailed research our technical venture investor, Alejandro Ballesteros, has compiled.


Just this morning, during our Decasonic Breakfast Series, we brought together some of the brightest crypto native minds in the space to encourage dialogue about the repercussions of the merge, and get a better picture of what is actually happening operationally. The technical leadership at our breakfast included core developers of leading Layer 1 blockchains, venture investors, technical founders, community members, and other web3 and metaverse full stack developers.


The conversation around the Merge has featured many debates about Proof of Stake vs Proof of Work, Macroeconomic backdrop vs Ethereum Narrative, among others. The merge represents an engineering update of unprecedented scale for a public production blockchain.


The Merge, in short, is an upgrade of the Ethereum blockchain from a Proof of Work (PoW) consensus mechanism in favor of Proof of Stake (PoS). This upgrade provides a few benefits, chiefly an energy efficiency that decreases the aggregate total network energy consumption by 99.9%.


So why is it the Merge? The Ethereum network has processed a little over 1M (1) transactions per day over the course of the last two weeks, generating an average of approximately $1/txn in fees (2), and having $33.1B (3) of Total Value Locked across the entire ecosystem. It stands to reason that altering the consensus layer of the protocol, i.e. the logic for agreeing what the canonical state of the Ethereum blockchain is, could introduce security risks that may place significant sums of money at jeopardy if not done incredibly carefully. Enter the Beacon chain. Instead of simply altering the consensus layer right away, the core development team sought to create a separate version of the blockchain that utilizes PoS in its consensus algorithm to allow for significant testing and monitoring before then merging the consensus layer of that chain with the execution layer of the current main net chain. The clients are now ready for the full migration towards PoS, hence the Merge.


The Merge improves settlement and sets the future capabilities around scaling. Ethereum, if it aims to be the settlement layer of the internet, could simply never have afforded to remain operational on its legacy Proof of Work network that confirms approximately ****12 to 25 transactions every second. For comparison, VISA confirms an average of 1,736 transactions per second (4). Additionally, the notion of when a transaction has settled (or become irreversible) is probabilistic, however, PoS transactions are declared finalized in 6.4 minutes (5) after which reversing the transaction would require obtaining and burning (1/3) of the total staked Ethereum. Although scalability upgrades were initially planned to be rolled out with the merge, the Merge will no longer increase throughput on the Ethereum blockchain. Initially, the Merge was going to implement sharding, a scalability technique that allows for transaction data to be split horizontally across different nodes in the Ethereum network.


”Sharding is a good way to scale if you want to keep things decentralized as the alternative is to scale by increasing the size of the existing database. This would make Ethereum less accessible for network validators because they'd need powerful and expensive computers. With sharding, validators will no longer be required to store all of this data themselves, but instead can use data techniques to confirm that the data has been made available by the network as a whole. This drastically reduces the cost of storing data on layer 1 by reducing hardware requirements. Sharding will eventually let you run Ethereum on a personal laptop or phone. So more people should be able to participate, or run clients, in a sharded Ethereum. This will increase security because the more decentralized the network, the smaller the attack surface area. With lower hardware requirements, sharding will make it easier to run clients on your own, without relying on any intermediary services at all. And if you can, consider running multiple clients. This can help network health by further reducing points of failure.” (6)


However, with the efficacy of L2 scaling solutions like Optimism, Arbitrum, and Polygon, the focus of the merge has shifted to predominantly a consensus mechanism switch. Yet, Sharding does still remain on the formal 2023 roadmap for updates post merge, and Proof of Stake will make this substantially more feasible.


”Plans for sharding are rapidly evolving, but given the rise and success of layer 2 technologies to scale transaction execution, sharding plans have shifted to finding the most optimal way to distribute the burden of storing compressed calldata from rollup contracts, allowing for exponential growth in network capacity. This would not be possible without first transitioning to proof-of-stake.” (7)

Another aspect of the merge that has been receiving significant attention is ETH issuance. Currently, ETH inflates at a rate of ~4.62% per year, 4.13% from ETH issued by PoW block rewards via block execution on Mainnet and 0.49% issued from block rewards via PoS on the beacon chain. Post Merge, since there will be no PoW consensus mechanism, the only ETH issued will be from block rewards via PoS validation. This means that ETH will only inflate by 0.49% per year. This is all of course assuming a burn rate of zero. It is important to note that the transition to PoS via Merging with Beacon chain will not impact the current burn mechanism.


“The Beacon Chain went live in 2020. Instead of miners, it is secured by validators using proof-of-stake. This chain was bootstrapped by Ethereum users depositing ETH one-way into a smart contract on Mainnet, which the Beacon Chain listens to, crediting the user with an equal amount on the new chain. Until The Merge happens, the Beacon Chain's validators are not processing transactions and are essentially coming to consensus on the state of the validator pool itself.” (8)


So what are the implications of the Merge?


We aim to provide these perspectives as a framework for you, the builder, developer, or creator, to consider as you further pursue your product development and growth in web3. None of this blog post should be considered as financial advice and these hot takes are subject to the evolving nature of complex ecosystems.


As venture investors with full stack expertise around product and growth, we at Decasonic always consider the implications of key technical milestones in our investible markets. This framework considers the relative impact by ecosystem participant and how this innovation may create headwinds or tailwinds.


Taking a participant perspective forms a starting point for our fundamental and thesis driven early stage investing and co-building. We believe in sharing this framework around innovation implications, it will also help builders, developers, creators and other investors to come join us in co-building the next stage of adoption for the mainstream.

Net net, the Merge is bullish for the mainstream adoption of Ethereum and broadly, blockchain innovation. Importantly, especially given the need for global coordination on climate change, a Proof of Stake Ethereum is bullish for our environment.


First, let’s consider the ecosystem participants that may face headwinds from the Merge:


1. Ethereum PoW GPU miners: The shift away from PoW consensus has the greatest headwind impact on the current Ethereum miners. No longer are they rewarded with Ethereum for maintaining this blockchain consensus and many of these compute resources will now need to be redeployed to other PoW blockchains or to other use cases outside of blockchain. There are efforts to sustain the Proof of Work Ethereum and there may be miners who support this fork of the blockchain.


2. Miner Extractable Value (MEV) traders: Given the Merge, it’s likely we see the game theory and economic incentives of MEV trading subside as validators now face economic and reputational penalties for exploitative behavior like this (9). Trading firms who rely on this strategy will face challenges to adapt.


3. Traditional Venture Capitalists: The Merge is a significant technological innovation that will catalyze mainstream adoption. Domain experts in blockchain recognize this, but many outside of this industry do not appreciate the magnitude and impact of this event. Many traditional venture capitalists may fail to catch up to their Web3 peers in forming their investment theses.


4. Bitcoin and other Proof of Work Layer 1 technologies: The Merge shows that blockchains can (and possibly should) upgrade to an energy efficient technology. Recently, policymakers in the US have signaled that responsible innovation in blockchain reflects this path away from legacy Proof of Work architectures and towards current day energy considerate technologies.


5. Other Layer 1 blockchains: Ethereum today is the incumbent blockchain for smart contracts. As incumbents accelerate their innovation, it drives competitive pressures to the technology challengers. Many other blockchains compete with Ethereum as “Ethereum killers,” differentiating on speed, energy efficiency, security and scalability. As Ethereum shows the capabilities to upgrade its technology, competitive differentiation starts to narrow and sustains the current day leadership this ecosystem holds. The competitive dynamics may also shift towards a multi-chain world, integrated closer to the application and user.


Importantly, many ecosystem participants will ride tailwinds in their efforts to sustain and accelerate blockchain innovations:


1. Ethereum Foundation and Vitalik Buterin: The long awaited technology upgrade was a pivot from Ethereum 2.0 to the phase one of a multi-step technology upgrade roadmap. The massive undertaking to merge the two chains on the execution and consensus layers of Ethereum now provides the developer energy and market momentum to complete the other stages of this innovation. Longer term, the ability to improve speed and throughput on Ethereum will further improve the longer term, durable utility of Ethereum.


2. The Environment: The long term impact on the environment cannot be understated. The biggest innovation resulting from the Merge is the energy efficiency. PoS is known to be more energy efficient because it doesn’t require mining via hashrate. Some estimates say that energy consumption will decrease by 99.95% once the Merge is complete, making Ethereum one of the more energy-efficient blockchains.


3. Creators: The Merge alleviates the environmental concerns for the $100B creator economy. Entire demographics of consumers had written off adopting blockchain technology due to the negative environmental consequences. An entire influencer category exists around sustainability maximalists, who may be more inclined to venture into web3 once The Merge is complete. For example, Leah Thomas’s (@GreenGirlLeah on instragram) reach extends to hundreds of thousands on **Instagram alone. The Merge will generate mainstream adoption as environmental impact will no longer be a main blocker for the average individual and creator. We may see more creators now lean into building DAOs, NFTs and other use cases on Ethereum because of the Merge.


4. Institutional Investors: The improved energy footprint provides a clear path for mainstream Institutional adoption, as the Merge has enabled a path towards ESG compliance for Ethereum but also related Layer 2 and ecosystem projects built on Ethereum. This event will catalyze the formation of this asset class.


5. Web3 Native Venture Capitalists: For many seed stage web3 native venture investors like Decasonic, the Merge validates their conviction in Proof of Stake, in Ethereum and related ecosystem projects, and in general, the mainstream adoption of blockchain innovations. It furthers confidence that the Ethereum ecosystem can adapt and innovate to market conditions. Execution wins and this is an impressive feat of engineering execution.


6. Long Term Investors of Ethereum: As net issuance of Ethereum decreases with the improved economics of blockchain usage, long term buy and holders of Ethereum gain additional confidence in the long term value accrual from less inflationary supply as well as an anticipated 3-7% yield on their stake.


7. Decentralized Finance (DeFi) projects in Ethereum and blockchain in general: Importantly, the yield provided by staking Ethereum tokens provides a reference rate of return and yield benchmark for other blockchain Decentralized Finance projects. Risk underwriting across DeFi lending, borrowing & derivatives will reference the relative credit underwriting versus Ethereum. This allows a natural hierarchy of credit quality to emerge, as protocol specific risk can be priced more efficiently when viewed relative to the baseline rate. It may even encourage a term structure of interest rates, something that DeFi has yet to adopt. With this reference rate of return solidifying the credit structure in blockchain, we may also see the financialization of other use cases: gaming/ e-sports, learning, training, and gig economy.


8. Developers and Builders: The Merge drives tremendous confidence from developers and builders in the ability of Ethereum to innovate on a medium and long term complex, technical roadmap. This engineering feat impresses many builders in the space and provides optimism for future improvements in speed and scalabilty. The Merge drives more confidence in working inside the Ethereum ecosystem and is validation that this ecosystem will likely sustain its leadership position. Hosting and running proprietary clients will become significantly easier as users will face lower barriers to participating in the blockchain’s consensus mechanism. This increases decentralization, and decreases the network’s exposure to node hosting infrastructure.


9. Future Innovators: We are bullish for the future use cases for the mainstream. The Merge will attract more creators, developers, and capital providers to unleash the cambrian explosion of innovations. Today’s use cases in blockchain are just the early implementations of how society in general will be impacted.


10. Mainstream: Proof of Stake consensus is a net driver of increased mainstream use cases and adoption. A reference annual interest yield for taking part in consensus lowers barriers for mainstream users to take part in the digital ecosystem that is the Ethereum Network, and earn rewards for maintaining it. In our informal discussions, we have seen this ability to generate an interest yield on a crypto asset generate mainstream interest. Even if something as simple as transaction validation is a user’s first foray into interacting with Ethereum, it is a powerful first step.


As investors and co-builders in blockchain innovations, we’re excited for this moment in blockchain history. We hope this perspective helps engage you in discussing and understanding potential market implications of this moment in time.


What are your hot takes? We’re always curious about other perspectives. Hit us up on linkedin, twitter, and other digital channels.



2. https://ycharts.com/indicators/ethereum_average_transaction_fee#:~:text=Ethereum Average Transaction Fee is,61.50%25 from one year ago.

6. https://ethereum.org/en/upgrades/sharding/#:~:text=Sharding is the process of,rollups over the entire network.



 

The content of this material is strictly for informational and educational purposes and is not meant to constitute investment advice or a recommendation or solicitation to buy or sell any asset or to make any financial decision. Nothing in these blog posts should be considered legal or tax advice. You should consult with your own professional advisor before making any financial decision. Decasonic offers no warranties on any content in the material posted in these blog posts, including that it is accurate, complete, or correct. The opinions expressed in these posts are those of the authors and do not necessarily reflect the views of Decasonic. Decasonic is not liable for any errors or omissions in the content of this newsletter or for any actions taken based on the information provided herein.

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