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Ethereum and its Transition to Ethereum 2
• A new blockchain, called Ethereum 2, will be launched in 2020 and employ a proof-of-stake based consensus algorithm.
• Ethereum 2 will have vast implications for scalability, security, decentralization and tokenomics.
• The ETH issuance rate would be considerably lower in the long run than it is today with the current specifications of Ethereum 2.
The Ethereum blockchain was launched in July 2015 with the vision of creating a “world computer”. Its core features are being programmable as well as enabling fast cryptocurrency payments. The capability to execute complex code on the blockchain enables “smart contracts” – contracts that are enforced automatically through code.
Looking Back: 2019 in a Wrap
Last year, development of the Ethereum blockchain has progressed significantly. In February, the network underwent the Constantinople hard fork – a planned upgrade which introduced various improvements to scalability and efficiency. Additionally, the upgrade delayed the “difficulty bomb”, which is an algorithm that exponentially increases the mining difficulty on Ethereum until mining becomes unfeasible (a period dubbed “Ice Age”). The goal of the difficulty bomb was to ensure an eventual transition to proof-of-stake. The block reward was also reduced from 3 to 2 ETH in Constantinople.
The next protocol upgrade of the current Ethereum chain occurred in December with the Istanbul hard fork. Istanbul brought several changes, such as reducing the cost of zero-knowledge proofs (“ZKPs”, originally introduced in the Byzantium hard fork) and enabling interoperability with Zcash. Cheaper ZKPs in combination with a technique called Optimistic Rollup allow for around 3’000 transactions per second on Ethereum – a large improvement to scalability.
However, the perhaps most intriguing development on Ethereum has not occurred on the protocol level, but on the blockchain directly: the rise of decentralized or open finance (DeFi), with an USD value of about $660 million locked in DeFi at the time of writing. The articles “The Decentralized Finance Revolution on Ethereum” and “How Decentralized Finance is Automating Central, Commercial and Investment Banking” of this report provide an in-depth overview of this fascinating development.
The State of the Ethereum Network
Illustration 1: The number of unique addresses on the Ethereum blockchain keeps increasing linearly since mid-2017.
Illustration 2: Currently, about 700’000 transactions are confirmed every day on Ethereum, which translates to a throughput of about 8 transactions per second.
Illustration 3: On average, about 520 ETH per day in transaction fees were paid to miners in 2019.
Illustration 4: Ethereum hashrate (red) has been on the decline throughout the bear market in 2018 but started recovering in 2019. The Byzantium and Constantinople hard forks reset the difficulty (blue) to lower levels.
Illustration 5: Nodes of the Ethereum network are distributed across the globe, with the most nodes hosted in the U.S., China, and Germany.
While the distribution of Ethereum nodes is fairly decentralized, concentration in mining pools is more of a centralization concern. The three largest mining pools combined – Sparkpool, Ethermine and f2pool2 – are responsible for about 64 % of the total hashpower. However, the requirements to help secure the Ethereum network are about to change – with Ethereum 2.
Ethereum 2: Overview and Recent Developments
Throughout 2020, major changes are coming to the Ethereum blockchain. As part of its Serenity upgrade, a new chain called Ethereum 2 will be launched. This will mark the start of Ethereum’s transition from a proof-of-work based consensus algorithm to proof-of-stake. In short, this means that the current model of mining will be abandoned – instead, the network will be secured by validators that sign off on transactions and include them in blocks. The computational resources required from validators will be much lower than in proof-of-work, which means that energy consumption – a highly controversial topic surrounding mining in general – will not be an issue anymore in the future for Ethereum.
The switch to proof-of-stake is highly anticipated, as it will be the most fundamental change to Ethereum ever since its launch in July 2015. The transition will be separated into multiple phases. However, the research part of later phases does not rely on completion of the previous phases – only the actual implementation does, meaning that a delay in e.g. Phase 0 does not necessarily affect Phase 1 and 2.
In this phase, the beacon chain will be launched, and validators will be able to put up ETH2 as stake to sign off on transactions, secure the network and earn rewards. This will necessitate the setup of one validator per 32 ETH2, as each validator require exactly 32 ETH2.
Illustration 6: The number of addresses holding at least 32 ETH has been steadily increasing, potentially indicating that smaller ETH holders are accumulating to stake once the beacon chain is live. This graph will spike once large ETH holders split up their holdings into chunks of 32 ETH to stake.
The launch is expected in Q1 2020, but a testnet running smoothly for at least one month is required first. Initial trials of Ethereum 2 node client interoperability were successful. The first step is then to migrate part of the ETH from the current chain to this completely new blockchain through a deposit contract – a smart contract which will enable a one-way bridge to move ETH from the legacy chain to the beacon chain. At the time of writing, the deposit contract is ready to be deployed, but developers are holding off until a final, inter-blockchain standard for one type of digital signatures (called Boneh-Lynn-Shacham or BLS) has been agreed upon.
Upon launch of the beacon chain, ETH2 will be issued on a 1:1 basis for each ETH that has been sent to the deposit contract. Most likely, this new cryptocurrency will initially be non-transferable at least until Phase 1. As such, it is highly likely that a futures market for the digital asset will evolve – and hence also a different price for ETH2 and ETH, which will converge when the legacy Ethereum blockchain becomes part of the new chain (see Phase 2).
The goal of this phase is to establish whether the base layer structure (i.e. the beacon chain) is stable, and to evaluate whether the economic incentives to stake and validate are sufficient.
During this phase, the shard chains will be established. Each shard can be viewed as a separate blockchain, and the beacon chain will act as a coordination layer between the shards. In the original proposal, the implementation of 1024 shards was planned. However, Vitalik Buterin proposed to reduce the number of shards to 64 – which would simplify cross-shard communication, meaning that interactions between shards (e.g. a token transfer from shard A to shard B) would proceed more smoothly.
Validators will be randomly assigned to shards from the pool of all validators. This reduces the chance that any set of validators could collude to take over a shard. Obtaining a truly random seed to base this decision on is hard, however – at least until quantum computers can provide provable randomness. In the meantime, randomness will be brought to Ethereum 2 through a complex algorithm that includes verifiable delay functions (VDFs). These functions are known to take a certain amount of time (102 minutes in Ethereum 2) to compute, and take arbitrary numbers provided by validators as inputs. The result will serve as a random seed for validator assignment to shards.
This “parallelization” of the blockchain through sharding will raise its capacity to around 1.3-2.7 MB/s, which should support a throughput of around 10’000 transactions per second initially – and potentially more, with the addition of more shards in the future as well as the efficiency optimizations currently happening on Ethereum (see above). For comparison – a global payment system such as VisaNet handles around 1’700 transactions per second on average.
This phase will introduce the full set of blockchain functionalities to Ethereum 2. It will be possible to execute smart contract code and transfer any tokens on the blockchain. The legacy Ethereum chain will be folded into an execution environment of Ethereum 2, meaning it will simply become a shard in the new chain – and all ETH remaining on the old chain will be transformed into ETH2. The state execution engine will be based on eWASM – Ethereum-flavored WebAssembly – and allow the compilation of high-level languages suitable for smart contracts.
Hence, this phase will also mark the end of the two-token model of ETH and ETH2 – at least in theory. There is a noteworthy chance that miners on the legacy Ethereum chain will conduct a hard fork and try to maintain the chain. If unsuccessful, miners will have to redirect their hashpower towards other proof-of-work chains mined with GPUs.
Overall, it should be mentioned that especially the later phases of Ethereum 2 are still subject to discussion and the final implementations have not been decided on. The timeline is also unclear – but the typical Silicon Valley mantra of “move fast and break things” does not work for an infrastructure is securing billions of dollars’ worth of assets.
Ethereum 2: Implications on Tokenomics
The switch from proof-of-work to proof-of-stake will also bring about significant changes to the economics of Ethereum. Currently, ETH is issued at a rate of about 4.8 % of the total supply per year.
Illustration 7: Daily issuance of ETH to miners has been subject to various changes over the years and is now sitting at around 12’500 ETH per day.
This issuance rate underwent several changes throughout the years. With the Byzantium hard fork in October 2017, the block reward handed out to miners was reduced from the original 5 ETH per block to 3 ETH. Constantinople further reduced the block reward to 2 ETH in February 2019. However, the difficulty bomb – which raises the mining difficulty and hence increases the time between blocks – was also delayed at the time of the forks, making sure total rewards do not drop further due to longer block times.
With Ethereum 2, this issuance rate will change again. Initially, the rate will increase slightly due to rewards being handed out on the beacon chain as well as the legacy chain. Assuming a (generous) 30 million of staked ETH, the annual issuance on Ethereum 2 would amount to 0.62 %, bringing the overall issuance on both Ethereum chains combined to about 5 %.
However, once Ethereum 2 is used to secure the legacy chain or – at the latest – the current chain becomes a shard, the issuance rate will be drastically lower. The 4.8 % of the total supply currently handed out over the year to miners will be unnecessary, leaving only the issuance on Ethereum 2 – which could range from about 0.4 % to 1.2 % with the current specifications. This would be equivalent to two of Bitcoin’s halving events conducted at the same time. Only time will tell how this change in the supply and demand equilibrium will impact the price of ETH – and the effects of this issuance rate change will be hard to separate from other price drivers. Also, the beacon chain first must prove that the currently suggested numbers are sufficiently attractive for validators to secure the network.
There is an additional proposal in the works that could strongly affect the total net ETH issuance: Ethereum Improvement Proposal 1559, or EIP-1559. The goal of this proposal is to simplify the fee markets by replacing the current first price auction model – where users regularly overpay on fees – with one that includes a “basefee” plus a tip for the miner or validators that includes the transaction in a block. The basefee would be burned, making the ETH of everyone more valuable, and miners or validators would only receive the tip. The main advantage of this way to structure fees is that they would be much more predictable: The basefee is known before creation of the block. This is in contrast to the current model, where network users only know what the minimum fee to get a transaction included was after a block has been mined.
Burning a large part of the transaction fee would also mean that the net issuance of ETH will be lower. As shown in Illustration 3, about 520 ETH per day are paid to miners as fees – or about 190’000 ETH per year. EIP-1559 would result in an additional decrease of the annual issuance rate of about 0.2 %. Depending on transaction volumes and fee markets, this could eventually even lead to negative issuance rates in the future.
Ethereum’s largest and most impactful network upgrade is coming in 2020 and the years ahead. The switch to Ethereum 2 will have vast implications for its scalability, security, decentralization, and economics. Throughputs of around 10’000 transactions per second are anticipated, and abandoning proof-of-work might improve decentralization as well as the carbon footprint of the network by strongly reducing the amount of computational work validators have to perform.
After a slight initial increase, the total issuance of ETH/ETH2 will drop to levels significantly below the current benchmark of around 4.8 % in the long run. Over the course of the next years, it will be interesting to see how the ETH market reacts to this shift of the supply and demand equilibrium.
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