Ethereum is the world’s largest programmable blockchain. It is the foundation for the future of the internet (Web3), and the future of finance (DeFi). Currently, more than half of the entire DeFi ecosystem exists on Ethereum. And despite market volatility and macroeconomic uncertainties, user engagement with Ethereum remains strong.
In this three-part series, we look at how the Ethereum ecosystem is building for the long term and is poised for growth. This series is adapted from the recently released ‘Impact of the Merge on Institutions’ report written by MetaMask Institutional and the ConsenSys Cryptoeconomic Research team. You can find the full report here.
As with any efficient technology, the Ethereum roadmap is full of upgrades to its infrastructure that make it future-proof. The first such upgrade, called the Merge, will occur in mid-September 2022. It will be a historic moment for the nascent crypto industry and will set up Ethereum for increased security, sustainability, and scalability.
Currently, the Ethereum network has two blockchain layers running in parallel – the layer running Proof of Work (PoW), called the execution layer (the historic state of Ethereum and block production), and the layer running Proof of Stake (PoS), called the consensus layer. The Merge will see these two layers merge, effectively ending PoW and transitioning the Ethereum mainnet fully to PoS.
Security is an important factor in the adoption of a blockchain. The Merge was designed to enhance the security of Ethereum through increased network participation and decentralization. But before we dive into these factors, we should understand the Ethereum Virtual Machine (EVM) and bridges.
The EVM is a platform where Ethereum data and smart contracts live. It allows developers to develop dapps on the Ethereum network as well as to easily port their code to other chains. For example, Ethereum devs no longer need to learn all the nuances of Solana, and can instead build on Neon EVM with much less friction to deploy their dapp on Solana. So, it adds a layer of composability and provides users the ability to perform all their transactions on the Ethereum network without needing to bridge to other networks.
Significantly popular infrastructure and applications already exist within the Ethereum ecosystem. This mitigates a notable existential risk of bridge hacks that other networks face since they often need to interact beyond their native network and with the Ethereum infrastructure.
In the past one year, over $2B have been stolen in bridge hacks (Figure 1). Some of the bridges that have been attacked include Axie’s Ronin, Solana’s Wormhole, Harmony’s Horizon and Nomad. While they are one of the greatest risks to blockchain security, bridges are not inherently part of blockchain security design. Instead, they are simply a means of moving liquidity across different networks.
One factor that can make other networks such as Solana and Arbitrum more attractive than Ethereum to developers and users is low transaction costs on those networks. Gas fees remain a function of demand. As a higher number of users come to Ethereum and transact on the network, the gas fees go up. And vice-versa.
The Merge, however, will set the stage for further upgrades that will help lower the cost of using the Ethereum network. A successful Merge will enable sharding, the next upgrade outlined in the Ethereum roadmap. Sharding is the act of splitting a network’s data into smaller portions to ensure easy storage of the data and avoid network congestion.
By reducing network congestion and enabling scalability, sharding will allow the Ethereum blockchain to process more transactions faster, effectively bringing down transaction costs. Therefore, developers and users will have less need to engage in bridging and risk their assets by moving between blockchains. They will be able to stay within the Ethereum moat for all their DeFi needs.
In addition to reducing bridging risks, the Merge will make Ethereum significantly more secure by making it overly expensive to attack. According to some estimates, hacking a blockchain running on the PoS mechanism will cost about 10-20X more than one operating on a PoW mechanism.
A key way through which the Merge enhances the security of Ethereum is by democratizing network participation. By ensuring that single-node validators get the same chance at earning rewards as a whale stake, PoS will lead to further decentralization of the Ethereum network.
In addition, it is difficult for a malicious actor to amass the 51% tokens required to launch an attack. Apart from being incredibly expensive to acquire that 51% stake on the network, it will be difficult to convince that many stakers to part with their stake. Currently, it will cost over $11B to launch a 51% attack on the Ethereum network for an hour.
Even if a bad actor manages to launch a 51% attack on the Ethereum network, the cost to sustain that attack will keep increasing because of a mechanism called slashing. If a validator attacks the network, their staked ETH will be burnt and their access to the network will be revoked. The attacker will effectively have to keep putting in more ETH, which will keep getting burnt, to sustain. Slashing is a mechanism that is unique to PoS, and makes it more expensive to attack the Ethereum network when compared with PoW.
Security of crypto investments is a top concern for institutional investors, ahead of even regulations and market volatility. According to a survey by Nickel Digital Asset Management, Europe’s largest regulated digital asset hedge fund manager, security is the main factor that affects an institutional investor’s engagement with crypto. By enhancing the security of the Ethereum network, the Merge addresses this key issue.
In the next part of this series, we will explore how the Merge affects Ethereum’s valuation in comparison to other Layer 1 networks. You can read more about the Merge and its impact on institutions in the full report, available here.
On September 12th, the key contributors to the report will talk about it on our “Breaking Down the Merge for Institutions” webinar. You can register for it here.