This week is a significant one in the history of Ethereum, the world’s largest programmable blockchain network. The most awaited upgrade to the networks since its launch, the move to Proof of Stake (PoS) consensus mechanism, is set to happen around September 15th. Called the Merge, the upgrade is the first in the Ethereum roadmap that will make the network’s infrastructure future-proof and set it up for increased security, sustainability, and scalability.
In our recently released ‘Impact of the Merge on Institutions’ report, we discuss in detail the opportunities that the Merge will create for institutions in the world of Web3. Written by MetaMask Institutional and the ConsenSys Cryptoeconomic Research team, the report also explores the factors, such as network activity, security, and valuation, which are setting Ethereum up for long-term growth and success. You can find the full report here.
While the Merge means institutions will have more attractive staking opportunities, improved security, and client diversity and interoperability, some long-standing criticisms of Ethereum such as high transaction costs and slower transaction processing, will still remain. In this post, we take a look at some of the threats to the Ethereum ecosystem that will remain after the Merge, some further upgrades that are planned after the Merge, and what the future of decentralized finance (DeFi) looks like for institutional investors.
Threats That the Merge Does Not Address
The PoS mechanism could introduce an existential risk of increasing centralization, censorship, and collusion in the Ethereum network. Following the Merge, large holders of ETH could theoretically interfere with the network’s performance. While this does not extend to catastrophic events like reversing transactions, it could potentially prevent finality from happening for an extended period of time, such as a day. One example of this existential threat is the growth of liquid staking derivatives on protocols like Lido Finance, Rocket Pool, and similar protocols. Lido, for instance, now controls nearly a third of all staked ETH. While there is decentralization within Lido (e.g. 21 validators on Lido responsible for staking), the potential attack vector is still there.
Improvements in interoperability pose an existential threat to Ethereum. This includes the emergence of cross-chain messaging protocols such as Axelar, the proliferation of protocols with built-in interoperability such as Cosmos and Polkadot, as well as improvements to bridge technology. All of these factors enable developers to build applications that are chain-agnostic while allowing users to move frictionlessly across chains with more security.
While the Merge may not directly address some of these criticisms, it does set Ethereum up for further upgrades outlined in its roadmap. The Merge is a step in the right direction. However, it is only the first one in the journey towards a better Ethereum.
The Ethereum Roadmap
The Surge
The first update after the Merge will be the Surge. The surge will allow the Ethereum network to scale massively through sharding. As an overall concept, sharding splits the data processing responsibility of a database (decentralized or otherwise) among many nodes, allowing parallel transaction, storing, and processing of information. As we mentioned in earlier sections, sharding will split the Ethereum network into shards, which will work as independent blockchains. Currently, Ethereum processes 15 transactions per second (TPS) on an average. Ethereum could reach processing capability of up to 100,000 TPS once its roadmap is complete, according Ethereum co-founder Vitalik Buterin.
Sharding will also tackle an existential threat to Ethereum posed by Layer 2s (L2s) such as Arbitrum and Polygon. Currently, Ethereum is significantly more expensive to use than most L2s.
Source: L2Fees
Well-established optimistic rollups like Optimism and optimized zk-rollups like Starkware direct usage away from Ethereum’s base layer, while settlement still ultimately resolves on the base layer.
Increasing transaction processing speed will allow Ethereum to reduce network congestion, which in turn can lower transaction costs. This is done through L2 hierarchical splits of tasks in rollups and parallel processing of unrelated tasks through sharding. At first these shards will function like rollups, bundling multiple transactions on each shard into one and then posting that one transaction to the Mainnet. Eventually, these shards will be able to function like independent blockchains, with their own smart contracts and account balances. Transactions between different shards will happen through cross-shard communication.
The Verge
The next phase of the Ethereum roadmap, the Verge, will focus on further increasing scalability of the network. This upgrade will work on optimizing storage through Verkle Trees, a kind of mathematical proof that is an upgrade to the Merkle proof Ethereum currently uses. By reducing the amount of data validators need to store on their computers to run operations, node sizes will shrink and allow more users to become validators. This will further decentralize the network and increase security.
The Purge
The Purge will reduce hardware requirements and streamline storage for validators by eliminating historical data and technical debt. This, in turn, will further reduce network congestion.
The Splurge
The final stage of the Ethereum roadmap will work on introducing smaller upgrades that will essentially fine tune the network. Buterin has referred to these upgrades as the “fun stuff”.
A good thing to remember here is that these upgrades will not necessarily follow one after the other. They are fairly independent, and are being worked on in parallel. The order of rollout of these upgrades has not yet been decided, but the work for all these upgrades is happening simultaneously.
The Future of Institutional DeFi
The Ethereum ecosystem is building for the long term. Despite current geopolitical and macroeconomic factors, and the recent market volatility—the community remains committed to building innovative products and systems, and institutional appetite for being a part of these innovations remains strong. Financial institutions—investment banks like Goldman Sachs and Barclays, hedge funds like Citadel Securities and Point72 Ventures, and retail banks such as Banco Santander and Itau Unibanco—are putting their money in crypto, or furthering their plans to offer crypto investment options to their clients.
As we continue to build through the bear market, we believe that the future of institutional DeFi is bright.
For a long time, the debate around institutional investment in crypto was about traditional finance (TradFi) vs DeFi. The increasing popularity of DeFi was often considered a death knell for TradFi. However, the digital asset management strategies of a number of TradFi companies in the downturn point to the fact that TradFi and DeFi are now coming together to complement each other. This trend is likely to increase post-Merge, as institutions acknowledge that it is all about the long game.
With the Merge increasing the security of the Ethereum network, and setting it up for future scalability, we expect institutions to become more keen to engage with the Web3 ecosystem.
For the past two years, DeFi innovation has created the infrastructure and tooling required for institutional DeFi adoption. From permissioned-lending pools that ensure only KYC’d participants, to on-chain asset management, MEV-resistant best execution protocols, and decentralized identity—more and more institution-focused projects have come to market.
We are also seeing L2 projects such as Optimism, Polygon, and Arbitrum achieve good DeFi volume for yield farming. We expect more institution-focused projects to come to market as L2 scaling accelerates post the Merge.
The transition to PoS has created compelling reward opportunities for institutions. With large holders of ETH—including cryptocurrency exchanges, funds, and custodians—already recognizing that holding ETH bestows a powerful position within DeFi, they have been able to earn rewards at 4.06% annual yield on their ETH positions. After the Merge, we expect real yield from ETH staking to be between 5.5% and 13.2%, depending on several factors such as block rewards, transaction fees, and maximum extractable value (MEV) accrued to validators.
Source: ConsenSys
The opportunities for institutional DeFi are vast, and the Merge will only help the market mature and create opportunities for investors chasing yield in high-risk areas. Institutional investors, who may have been skeptical about the investment opportunities of DeFi earlier, have now come to recognize the growth of Web3 and its related financial instruments powered by DeFi to be inevitable. They may not yet fully understand the drivers behind DeFi or Web3, but have learned that the asset class cannot be ignored.
Ethereum’s next phase on the roadmap will tackle the challenges of scaling, thereby building confidence in the ecosystem, especially among those who may see crypto assets as too risky an investment. We expect progress and innovation to come fast, whether from cryptonative funds and DAOs, or traditional Web2 institutions.
This post is adapted from our exclusive report, “The Impact of the Merge on Institutions”, in which we discuss how changes to the Ethereum network as a result of the Merge will translate into opportunities for institutional investors.
You can download the full report here.
On September 12th, the key contributors to the report talked about it on our “Breaking Down the Merge for Institutions” webinar. You can watch it here.
