From PoW to PoS: the Ethereum Merge's game-changing impact explained

If there is one event that stood out as a game changer in the cryptocurrency sector in 2022, it would certainly be 'The Ethereum Merge.'

On September 15th, 2022, Ethereum, the second-largest cryptocurrency by market capitalisation and the first smart contract blockchain, underwent a historic transformation. The upgrade marked a transition from the energy-intensive proof-of-work (PoW) to the eco-friendly proof-of-stake (PoS) consensus mechanism.

The fundamentals of PoS transformed the role of ETH. The cryptocurrency that was once used to reward crypto miners is now staked. The stake safeguards the integrity of the blockchain, as ill-behaved validators risk losing it completely in a process known as slashing. For instance, validators incur penalties if they fail to identify the head of the chain on time (the most recent block to be added to the blockchain) or if they double-sign transactions.

Consequently, the security of the Ethereum blockchain witnessed a significant enhancement post-Merge. To launch an attack, one would need to control over 51% of the blockchain's total value. While theoretically feasible, such an attacker would expose themselves to substantial penalties and the likelihood of being expelled from the network.

The decision to move to PoS was also fueled by Ethereum's commitment to sustainability and reducing its carbon footprint. This objective was successfully achieved, at least when we look at Ethereum's annualized energy consumption: this metric is now approximately at 7.5 TWh according to the Crypto Carbon Ratings Institute (CCRI), and it is consuming 15 times less energy than Bitcoin.

These were not the only objectives sought; the public was certainly expecting much more. The 'Merge' is more than just a technical or an environmental shift: it is the first step towards further changes to improve scalability and reduce transaction costs. These ultimate changes are set to reshape Ethereum's role in the industry and appeal to a larger audience.

Meanwhile, the ‘Merge’ also created new challenges that we will mention in this article.

Energy Efficiency and Environmental Impact

Ethereum's recent shift from a power-hungry proof-of-work to a greener proof-of-stake consensus mechanism has significantly enhanced its energy efficiency according to the CCRI metric. This transition minimized energy consumption, reducing its carbon footprint. The graph below, produced by CCRI, shows the impact of the Merge in September on the chain's electricity consumption: it has been reduced by an impressive 99.5%.

However, some analysts and developers would reasonably argue that the CCRI metric does not reflect the true environmental impact because there are more than 925,000 validators today, representing tens of thousands of computers running almost 24/7. As Vitalik Buterin reminded us during the recent Korea Blockchain Week, it should be cheaper and easier to run a PoS node than it was to mine Ether through PoW. Still, there are many more validators now than there were miners pre-Merge. Therefore, the true energy-saving advantage of PoS over PoW might not be obvious.

Furthermore, developers are planning to introduce the concept of 'stateless clients' that would allow a user to run a node on their mobile phone, leaving the heavy task of storing the Ethereum block history to 'state providers.' This would favour decentralisation but also increase the number of devices and deteriorate energy efficiency.

Enhanced Scalability and Reduced Transaction Costs

The Ethereum Foundation has clarified that we should not anticipate significant enhancements in transaction speed and costs following the Merge. Bitinfocharts produces a graph depicting the average transaction fees on the Ethereum network since 2021.

The average transaction fees on Ethereum stand at approximately USD 2.389, compared to USD 1.585 on the Bitcoin blockchain. The decline in fees observed during the latter half of 2022 primarily reflects the start of the liquidity crisis triggered by the collapse of the TerraUSD protocol.*

Regarding transaction speed and fees, the subsequent ‘Proto-Danksharding‘ and ‘Danksharding‘ aim to make notable improvements. As explained by the Ethereum Foundation, these upgrades are designed to ‘make transactions on Layer 2 as cheap as possible for users and scale Ethereum to >100,000 transactions per second‘.

A Layer 2 solution constitutes a separate blockchain constructed atop the Ethereum network, extending its functionalities. The 'rollup' operations (layer-2 transaction operations) inherit Ethereum's security assurances. Typically, Layer 2 solutions concentrate on enhancing scalability, with Optimism and Arbitrum being among the most prominent options.

Galaxy graphed the daily average transaction fees on Optimism and Arbitrum since November 2021.

Currently, the average fee for layer-2 transactions stands at USD 0.0335, although it may surge above USD 1 during periods of heightened activity. Anticipated for release in Q4 2023, the Proto-Danksharding upgrade (EIP-4844) is expected to improve scalability and reduce transaction fees substantially. **

Reshaping the Crypto Industry

Regardless of our agreement or disagreement on the environmental advantages of the Merge, this undertaking alone has established a precedent for the cryptocurrency sector. It signifies a step towards sustainability and serves as a statement that even the most established and widely used blockchains can undergo significant transformations.

It also brought about significant alterations in the tokenomics of the Ethereum ecosystem. Among the most relevant changes for users:

• Miners have been supplanted by prominent staking protocols such as Lido. Through the provision of staking services to individual investors, Lido succeeded in elevating its staking share on Ethereum to more than 30%, potentially undermining the decentralisation principle of the blockchain.
• A portion of the fees incurred for transactions on the chain is now subject to burning, rendering the overall supply of Ether deflationary as network activity continues to expand over time.
• A net amount above 300,000 Ethers has been burnt since the Merge as reported by Ultra Sound: the Ether total supply decreased by 0.25%.

Finally, it also changed the legal standing of the blockchain for better or worse as the SEC turned its attention towards PoS. Since the Merge, the SEC has been considering classifying native cryptocurrencies from PoS protocols as securities. Consequently, Ethereum may find itself at the forefront of significant legal battles.

*The value of cryptoassets may fluctuate significantly over a short period of time. The volatile and unprecedented fluctuations in price may result in significant losses over a short period of time. Any Cryptoassets may decrease in value or lose all its value due to various factors including discovery of wrongful conduct, market manipulation, change to the nature or properties of the Cryptoasset, governmental or regulatory activity, legislative changes, suspension or cessation of support for a Cryptoasset s or other exchanges or service providers, public opinion, or other factors outside of our control. Technical advancements, as well as broader economic and political factors, may cause the value of Cryptoassets to change significantly over a short period of time.

** The prices of Cryptoassets fluctuate, sometimes dramatically. The price of a Cryptoasset may move up or down and may become valueless. It is as likely that losses will be incurred rather than profit made as a result of buying and selling Cryptoassets.