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HOW THE ETHEREUM MERGE MAY IMPACT THE CRYPTO ECOSYSTEM: ON-CHAIN INDICATORS TO
WATCH

September 7, 2022
September 7, 2022 | By Chainalysis Team

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On or around September 15, 2022, the Ethereum blockchain is expected to switch
its consensus mechanism from proof-of-work (PoW) to proof-of-stake (PoS). Under
PoS, validators “stake” the blockchain’s native cryptocurrency by sending it to
a smart contract where it stays locked, with one validator chosen at random to
confirm each new block and receive the associated reward. In Ethereum’s case,
validators must stake 32 Ether, but users can receive staking rewards with less
by joining a staking pool. PoS is more environmentally friendly than the PoW
consensus mechanism, under which miners compete to validate new blocks by
expending large amounts of computing power and electricity. In addition to the
environmental impact, many believe the switch to PoS can reduce the risk of
over-centralization by opening up the validator role to anyone with Ether to
stake, as opposed to just those with expensive mining equipment. 

Ethereum’s switch is known as “The Merge” because Ethereum’s PoS blockchain,
known as Eth2, has been operating in a testing state known as the Beacon Chain
since late 2020. With The Merge, Eth2 and Eth1 will come together to form one
blockchain, with Eth1 acting as the execution layer handling transactions and
Eth2 as the consensus layer handling PoS consensus. Below, we’ll look at a few
possible knock-on effects of The Merge, as well as the on-chain indicators
observers can use to track those effects.


INCREASED ETHEREUM STAKING FOLLOWING THE MERGE

One of the first questions is whether The Merge will spur more staking activity
on the Ethereum blockchain.

Users have already staked more than $30 billion worth of Ether on the Eth2
blockchain, making it the biggest PoS blockchain by value staked before even
replacing Eth1. Some have staked directly by setting up their own validator
nodes, which requires specialized software and hardware in addition to 32 Ether.
Others have staked by sending Ethereum to a staking pool — similar to a mining
pool, staking pools allow several users to pool their resources, increase their
chances of being selected to propose a new block, and share the rewards amongst
themselves.




Staking could become an even more attractive proposition following The Merge for
a few reasons. For one, users will likely become more comfortable staking once
PoS is officially in place and PoW is left in the past. The switch to PoS will
also make Ethereum more eco-friendly, which could make  investors with
sustainability commitments more comfortable with the asset. This especially
applies to institutional investors, who we’ll cover more later. 

Finally, The Merge also sets the stage for future improvements to Ethereum.
Right now, Ether staked directly on Eth2 is locked in the contract and cannot be
withdrawn. Some staking services provide liquid, synthetic assets representing
users’ staked Ether, but those synthetics don’t always maintain a 1:1 peg with
Ether. While The Merge won’t change this immediately, an update known as the
Shanghai upgrade, planned for six to 12 months following The Merge, will allow
users to withdraw staked Ether at will, providing more liquidity for stakers and
making staking a more attractive proposition overall. Sharding and other
scalability improvements intended to lower gas fees and increase transaction
speed are also on the horizon following The Merge. 

Taken together, these changes, starting with The Merge, should make Ether a more
attractive asset to hold, and therefore to stake as well.


INSTITUTIONAL INVESTORS EMBRACING ETHEREUM

In addition to increased staking overall, we’ll also be on the lookout for
institutional investors specifically to begin or ramp up their Ethereum staking
activity. 

We’ve written before about how the prices of cryptoassets like Bitcoin have
become more correlated with those of tech stocks and other high-risk,
high-upside assets. However, Ether’s price could decouple from other
cryptocurrencies following The Merge, as its staking rewards will make it
similar to an instrument like a bond or commodity with a carry premium. Some
predict that between staking rewards and transaction fees distributed to
validators, stakers can expect Ether yields of 10-15% annually, and that’s
before factoring in the potential for the price of Ether itself to rise, which
would also increase returns in terms of fiat value (of course, Ether’s price
could also fall, which would hurt fiat returns). Those returns could make
Ethereum staking an enticing bond alternative for institutional investors. For
comparison, yields for one-year U.S. Treasury bonds sit at 3.5% as of September
2022, though that number has been rising over the past year.

The data shows that the number of wallets staking $1 million or more worth of
Ether — which we’ll refer to as institutional stakers — has been steadily
increasing already. 



It’ll be interesting to see if the number of institutional-sized stakers
increases at a faster rate following The Merge, as this could suggest that
institutional investors do indeed see Ethereum staking as a good
yield-generating strategy. 


ETHEREUM MINERS WILL HAVE TO GO SOMEWHERE, BUT BITCOIN PROBABLY ISN’T AN OPTION

Ethereum’s switch to PoS will also necessitate changes in mining activity. Right
now, many miners and mining pools mine assets across several different
blockchains, dynamically distributing their hashrate between blockchains based
on market trends. Generally though, most mining focuses on Bitcoin and Ethereum.




After The Merge, hashrate dedicated to Ethereum mining will either disappear or
disperse to other blockchains. However, don’t expect that hashrate to move to
Bitcoin. Why? The equipment used to mine Ethereum won’t cut it for Bitcoin. Most
Ethereum miners use computer processors known as GPUs (graphical processing
units), while Bitcoin miners use more powerful processors called ASICs
(application-specific integrated circuits). While GPUs are too weak to
profitably mine Bitcoin, the Ethereum blockchain was designed to be
ASIC-resistant, meaning it requires a type of hashing that cannot be performed
by ASICs. That means Ethereum’s switch to PoS is a huge blow to GPU miners.
Ethereum currently makes up 97% of all GPU mining activity, and all remaining
GPU-mineable coins have a collective market cap of just $4.1 billion, a mere 2%
of Ethereum’s. That’s not enough to support GPU miners. 

So, does this mean that millions of once-productive GPUs will now sit idle,
their owners bereft of opportunities to make money in cryptocurrency? Not
necessarily. There are several services built on the Ethereum blockchain that
tap into the power of distributed GPUs to accomplish specific computing tasks in
a decentralized manner, with GPU owners receiving Ether or ERC-20 token rewards
in return. Consider the two following examples:

 * Livepeer is a decentralized video streaming service that allows GPU owners to
   transcode video in exchange for cryptocurrency rewards
 * Render Network offers a similar service for the rendering of 3D images, and
   also allows GPU owners to collect cryptocurrency rewards in exchange for
   donating computing power

The graph below shows the number of weekly Ethereum transactions sent from the
LivePeer and Render smart contracts, some of which reflect rewards to GPU owners
contributing to the services’ respective networks (note: the graph doesn’t
include rewards paid out in each network’s native token). 



While on-chain activity has declined of late, it’ll be worth monitoring whether
these networks and similar ones pick up due to an influx of GPU owners seeking
yield opportunities following the Ethereum merge. Of course, there are
non-crypto uses for GPUs as well, such as providing processing for data centers,
gaming computers, and other heavy-duty machines. Some miners may opt to sell
their GPUs to businesses operating in those industries. 


THE MERGE’S IMPACT ON CRYPTO MARKETS STARTS WITH ON-CHAIN DATA

Overall, The Merge could have big implications for Ether’s price and overall
attractiveness as an asset, which in turn impacts staking, mining, and
institutional adoption of cryptocurrency. While it’s impossible to predict the
exact market reactions or how pronounced they’ll be, the on-chain metrics we
outline above can help you track them following The Merge.


HOW CHAINALYSIS WILL SUPPORT CUSTOMERS POST-MERGE

In addition to impacts on legitimate cryptocurrency usage, we’ll also be on the
lookout for cybercriminals seeking to take advantage of confusion around The
Merge. The Ethereum Foundation has posted warnings about scams that, for
instance, ask users to send Ether to an address in order to “upgrade to Eth2.”
If any such scams gain traction, we’ll be ready to provide the tools and
services to support our law enforcement and private sector partners in tracking
the activity of those responsible. 

There’s also the possibility that if enough miners don’t want to comply with
Eth2’s PoS requirements, they could create a rival fork of the Ethereum
blockchain that continues with PoW. While we don’t expect this to happen,
Chainalysis will keep an eye on any emergent forks that gain traction and be
ready to evaluate our customer needs around support of the new fork. If The
Merge proceeds as expected, Chainalysis customers don’t need to do anything to
receive our continued support on the canonical Ethereum blockchain once it
switches to PoS.  

This website contains links to third-party sites that are not under the control
of Chainalysis, Inc. or its affiliates (collectively “Chainalysis”). Access to
such information does not imply association with, endorsement of, approval of,
or recommendation by Chainalysis of the site or its operators, and Chainalysis
is not responsible for the products, services, or other content hosted therein. 

This material is for informational purposes only, and is not intended to provide
legal, tax, financial, or investment advice. Recipients should consult their own
advisors before making these types of decisions. Chainalysis has no
responsibility or liability for any decision made or any other acts or omissions
in connection with Recipient’s use of this material.

Chainalysis does not guarantee or warrant the accuracy, completeness,
timeliness, suitability or validity of the information in this report and will
not be responsible for any claim attributable to errors, omissions, or other
inaccuracies of any part of such material.

DataEthereumResearchThe Merge

Author Chainalysis Team



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