Ethereum 2 Is Coming
Nov 16, 2020
Last week, all eyes were focused on the U.S. presidential election on Nov. 3. As the event unfolded and uncertainty in the markets about likely outcomes was reduced, strong performances across the board were observed.
Illustration 1: Since the beginning of November and through the U.S. election week, BTC and ETH both performed strongly, up 11% and 16% at the time of writing, respectively. The dollar showed continued weakness.
However, while the attention of the world was pointed elsewhere, the crypto space achieved another major, long-anticipated milestone: the official launch of the deposit contract for Ethereum 2. The price of ETH reacted impulsively to confirmation that this was the official deposit contract through a tweet by Ethereum co-founder Vitalik Buterin.
Illustration 2: ETHUSD at the time of the official deposit contract announcement. The black arrow indicates the timing of Vitalik’s tweet, which was followed by a sharp 5% increase.
The deposit contract itself was already deployed on Oct. 14, although the authenticity of the contract remained unclear. A bit of trivia: The deposit contract was deployed from an address funded through tornado.cash, a privacy protocol on Ethereum leveraging zero-knowledge proofs, and the rest of the funds were donated to WikiLeaks.
The launch date for the beacon chain (Ethereum 2 Phase 0, see below) is now set for Dec. 1 barring any unforeseen complications. For this to occur, 524’288 ETH need to be deposited to the deposit contract, corresponding to the 16’384 validators required to start the new blockchain (since each validator needs exactly 32 ETH). Roughly 47’500 ETH have been deposited so far (Nov. 8).
What Changes? The main change for crypto markets that the launch of the beacon chain will bring is ETH staking. ETH will immediately become the cryptocurrency with the highest market capitalization that runs under Proof-of-Stake and hence offers the possibility to stake. The rewards for staking are expected to fall in the 10-15% range initially (0.8-2M ETH staked), and drop relatively quickly down to 6-10% (2-6M ETH staked) if more people decide to stake their ETH.
These large amounts of ETH locked up in the deposit contract might also lead to higher volatility for ETH markets. Additionally, the fact that ETH staking exists and is likely to pay out decent rewards also means that borrowing and lending rates for ETH in DeFi protocols such as Compound or Aave could adjust.
The participation rate in the beacon chain (meaning how many people decide to stake) will also show whether the economic incentives are properly designed and sufficient to attract enough validators. It will be the first test with real capital at stake to demonstrate that what worked well in various Ethereum 2 testnets (such as Medalla) will also work in mainnet reality.
In the short term (until Phase 1.5, see below), overall issuance of ETH will also increase, since the cryptocurrency will be used to secure both the current Proof-of-Work Ethereum chain as well as the new beacon chain. This will bring overall issuance from currently about 4% to roughly 6%.
What Stays the Same? Ethereum will not become immediately more scalable because of the launch of the beacon chain – the benefits to scalability will only show up at later stages of Ethereum 2. On a sidenote though, other scaling techniques have recently been shown to be promising.
Staked ETH will not be transferable at least until Ethereum’s Phase 1 – which is why it is also called “beacon ETH”, “bETH”, or “ETH2” until full fungibility with non-staking ETH is restored. This also means that part of the overall newly issued ETH (projected to be around 6% annually) will remain locked up for some time. In a previous episode on Ethereum 2, the possibility of an ETH2 futures market developing was also outlined, with some thoughts on possible liquidity premia for such a market.
The current Ethereum chain will continue operating as usual – at a later stage, the plan is to merge it with the new Ethereum 2 chain. This also means that the only action that is required by ETH holders is to decide whether to stake or not to stake.
Ethereum 2 Phases and Current Developments The phases that Ethereum 2 will go through have been outlined in detail in the Outlook2020 report; here is a short recap of the most important facts:
• Phase 0: This phase involves the launch of the beacon chain. It does not represent a fully functional Ethereum blockchain yet, but simply provides the base layer and serves as a test for the economic incentive structure of ETH rewards for validators.
• Phase 1: In phase 1, sharding is introduced. Shards can be thought of as separate blockchains running on top of a coordination chain (in this case the beacon chain), and this parallelization of the blockchain is expected to lead to significant scalability advantages. “Beacon ETH” might become transferable already in this phase.
• Phase 2: Finally, this phase is when the new Ethereum chain will become fully functional, including e.g. smart contract capabilities. The old (current) Ethereum chain would be integrated into the new chain as a shard.
Research on the individual phases happens in parallel, not in sequence – problems and roadblocks that later phases face can be solved while earlier phases are still in the process of implementation.
Several newer developments that have found broad community support are related to the introduction of a “Phase 1.5”. Phase 1.5 would integrate the current Ethereum chain as a shard in Ethereum 2, leading to a sharp drop in ETH issuance (by about 66%) and the end of Proof-of-Work on Ethereum. Even more recently and in the light of promising scaling techniques such as zero-knowledge rollups, a “Phase 1.5 and done” approach found more support.
In this approach, shards would serve as data availability layers: Their main purpose would be to immutably record zero-knowledge proofs of transactions and smart contract interactions. Most of the actual transfers and contract execution would happen on the second layer. The argument for this is that second layer solutions already today offer possibly greater scalability gains than what the original Ethereum 2 roadmap could bring. It is the combination of the two that has the potential to bring Ethereum to >100k transactions per second needed for a globally used settlement layer while remaining sufficiently decentralized.
Conclusion Ethereum 2 is finally within reach, but the path towards a fully functional proof-of-stake based Ethereum chain is still long. Nonetheless, this is a major step for Ethereum overall, and one that has been planned since the very first block in July 2015. The years of research might finally pay off, and the rewards in terms of chain security and scalability can be reaped.