Ethereum 2.0 or how the Ethereum Merge is changing the blockchain world

Ethereum 2.0 Merge Image

They say that boxers never come back after losing. Will Ethereum 2.0 change that? Ethereum is the former heavyweight champion, beaten by a handful of established Chains with technological innovations. But with the coming switch from Proof of Work to Proof of Stake, it is now the champion’s hour.

Ethereum was probably the most important project in the first blockchain wave, offering smarter features than its technological father Bitcoin. Ethereum’s cryptocurrency Ether is money just like Bitcoin is, but beyond that, it is programmable money that can be enriched with features and contracts (What is Ethereum and how does it work?). Even better, it allows five times more transactions than Bitcoin. However, that’s not as spectacular as it sounds, considering Bitcoin allows 3-7 transactions per second. Visa’s credit card network can handle 6,000 financial transactions at the same time. Suddenly, the limitations of blockchains versus the real (database) world become apparent.

There is an old saying, “The Phoenicians invented money. But why so little?” You could ask a blockchain the same question. If it could, it would answer, “I have a trilemma. There’s the speed, there’s the degree of decentralization, and there’s the cost. You can only have two of the three.” Visa is fast (i.e., it can do many transactions at once) and relatively cheap. But it’s a centralized network that puts power in a single hand (or two). A blockchain always offers decentralization. That’s its main advantage. But the greater the degree of decentralization, the more expensive it becomes to maintain or the slower the network becomes (or both).

The trilemma of blockchain is a law comparable to gravity. Mankind believes it can one day overcome it, but no one has actually achieved it. That’s not because we haven’t tried. Every 18 months or so, a new technological development spawns a new wave of blockchains. New concepts with strange names like sharding or off-chain push the scaling envelope without ever solving the underlying problem.

Ethereum has one of the smartest founders in Vitalik Buterin, and the community around the protocol is huge and very active. They have long solved some of the technological problems – improving the ridiculous transaction limit and the proof-of-work mechanism that requires an investment in electricity to maintain. But these take many years to implement. In crypto time, that would be centuries.

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Regardless of the problems, Ethereum quickly became the most widely used blockchain and still is, its market capitalization is several hundred billion dollars, thousands of companies are built on it. This makes innovation difficult. Implementing new solutions is always a risk because it requires the programming equivalent of open-heart surgery. The more valuable the network became, the riskier the change.

Years passed. Ethereum went through all the classic phases of the innovation cycle:

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When Ethereum launched in 2014 (Phase 1), it was innovative. Innovation brought traction and rapid growth (Phase 2). As Ethereum’s position in the market matured, resistance to change built (Phase 3). Ethereum has now reached phase 4. It has reached its zenith, tying up the most value in decentralized finance (DeFi) and NFTs.

However, it is not alone in the industry. Blockchains have evolved, becoming faster, more convenient, and cheaper, but probably less decentralized (think Trilemma). Unable to scale transactions, Ethereum scaled in price – increasing demand made each transaction more and more expensive. Ethereum became a victim of its own success.

Ethereum’s attempts to scale

Ethereum has found two areas where it can modify its structure to make it suitable for the “real world.” One area revolves around the consensus mechanism. A bank has a central record book, and only that entity tells who owns what and who sent what to whom. They rarely have to prove their records in detail to the public. In a decentralized blockchain, on the other hand, records are stored on multiple computers called nodes. In a centralized blockchain like EOS, the “truth” is stored on 21 nodes; in Bitcoin, it’s several thousand.

When a transaction is made, it must be updated on each node. If a node is tampered with or simply offline, its record will be different from the others. The most important task of a blockchain is to establish and maintain the consensus of truth. One protection against tampering is to make tampering prohibitively expensive. Since the consensus mechanism is the only vulnerability, consensus must also be expensive relative to the overall value of the blockchain.

Early blockchains, including Ethereum, made consensus expensive by adding seemingly pointless, energy-intensive computations. Costs increase with blockchain usage and value. Bitcoin is the most valuable chain at nearly a trillion dollars, so the cost of maintaining consensus (and the cost of trying to manipulate it) costs the same amount of (computer) energy that Argentina expends.

The newer blockchain has replaced this so-called Proof of Work (PoW, let computers work) with a consensus mechanism called Proof of Stake (PoS). This replaced the cost of energy with tying up money (like in a savings account). The same person who spends a small country’s worth of energy (and receives valuable coins in return) now puts a lot of coins into a lockbox and buys the right to participate in consensus building. With PoS, there is no waste; it makes the network more efficient.

A second area is a technology called sharding. A classic blockchain, which so far includes Ethereum, stores transactions in a large ledger. As each day passes, it grows and becomes more unwieldy and therefore slower. With sharding, the book is broken down into many smaller parts and stored decentrally. As a result, less data is sent through the vastness of the internet – the blockchain becomes faster.

Both of these changes in Ethereum’s source code are intended to speed up the blockchain from 15 transactions per second to 100,000. Now it’s about using it for something other than a handful of bored monkeys.

The rocket builder’s fear of the launch

In 2022, the time has come. The long-awaited “Ethereum Merge Date” is just around the corner. Ethereum is venturing into a new technology. The first ignition stage of the Ether-powered rocket is the switch from Proof of Work to Proof of Stake. Since April 2022, Ethereum has been running the old energy-guzzling blockchain (Ethereum Main net or also ETH 1) and in parallel a new one based on Proof of Stake. It is called Beacon Chain or also Ethereum 2.0.

Both chains now contain the same transactions, and with each new one, the associated record is stored in both chains. However, it is not enough to simply shut down the old one. Both Chains must now be merged. Since all the value in the Ethereum Blockchain is stored in the associated software, a mistake in the transition would be catastrophic. Like in a space shuttle, a metaphorical leaky seal could lead to terrible losses.

Last June, this merging was tested for the first time, with the Ropsten Test Network (testnet) connecting its proof of work layer to the new beacon chain. With success! But now the pulse of the Ethereum technicians is rising, in the first half of August the dress rehearsal with the so-called Goerli Merger is to take place – a final test before the billion dollar switch is flipped.

What do Ethereum miners do after the merge?

In a nutshell, something different. Ethereum mining has quite a complex infrastructure. There are thousands of individuals and many companies mining new Ether with their own hardware and energy. Theoretically, they could generate other coins with their mining rigs. But this is not very promising. For example, Bitcoin mining requires different hardware than Ether, so the old rigs cannot be used for the most important of all blockchains. In addition, among the so-called GPU miners (which are powered by graphics cards), Ethereum is so dominant that it is not worth mining other coins.

Miners are mostly grouped together in mining pools. These work like lottery communities, the probability of winning is increased and the profit is distributed among the participants. The pools earn money not so much from active mining, but from management. They are already prepared for the merge, now the members can provide Ether for Proof of Stake (i.e. staking) instead of mining.

Is Ethereum 2.0 changing our lives?

At first, we probably won’t notice much. Our wallets will still show the same Ether, there is no new coin. The first question will always be about the gas fees, that is, the usage fee. If the Beacon Chain can handle so many more transactions, shouldn’t it be cheaper? There is no clear answer to this question (yet). That’s because network costs are variable. They are driven by demand. The network operator (here the Ethereum Foundation) has only limited control over the gas fee. Experts on Twitter are discussing this question very lively right now. The switchover will tell. But when will it happen now?

The Ethereum Merge Forecast

No software conversion runs without errors. Thus, problems are also to be expected with the Ethereum Merge and thus also with delays. The actual merge is still planned for 2022. The entire crypto and blockchain community is looking forward to what is perhaps the most important crypto event since the invention of Bitcoin.

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ETH Merge

Tax implications of the Ethereum Merge

In terms of taxes, the most significant event related to the merge is the announced hard fork introducing the Ethereum PoW (ETHW) chain, but also the transition to Proof of Stake on the main chain introduces new variables in terms of potential taxable events.

Disclaimer: The information provided in this blog post is for general information purposes only. The information was completed to the best of our knowledge and does not claim either correctness or accuracy. For detailed information on crypto regulations, we recommend contacting a certified legal advisor in the respective country. If any questions occur, feel free to contact us on our social media channels.

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