The Upgrade Path of Ethereum

Author: IOBC Capital

Ethereum is positioned as the world's computer. To achieve this goal, developers planned an upgrade path from the very beginning, consisting of four phases: Frontier, Homestead, Metropolis, and Serenity.

Currently, the entire network has reached the third phase, with the first three phases belonging to Ethereum 1.0, while the final phase, Serenity, is what we often refer to as Ethereum 2.0 (to avoid confusion, the Ethereum official team has abandoned the term Ethereum 2.0, but we will continue to use this conventional terminology in this article).

The Ethereum 2.0 upgrade is primarily aimed at addressing some limitations that have arisen during Ethereum's development, which hinder the overall network's growth. The main issues are as follows:

• First, the high energy consumption caused by mining. Due to the use of the PoW (Proof of Work) mechanism as the consensus mechanism, Ethereum requires nodes to provide computational power for mining, and the various mining processes consume a large amount of electricity, leading to frequent criticism that the network is not environmentally friendly.
• Second, the performance issue. Currently, the block generation speed on the Ethereum chain is about one block every 12-15 seconds, with a TPS (Transactions Per Second) of around 15. This processing speed is insufficient to support a typical commercial application. The occasional congestion on the Ethereum network also limits its development.
• Third, the issue of usage fees. Using the Ethereum network requires paying gas fees to the miners maintaining the network, which typically range from a few dollars to several dozen dollars, depending on network congestion, and at peak times can even reach hundreds of dollars. The high gas fees have led some protocols to turn to Ethereum's competitors, such as Solana and Near.

To address these issues, the developer community has planned several steps for the Ethereum 2.0 upgrade. The following will introduce the roadmap for the Ethereum 2.0 upgrade.

Ethereum 2.0 Roadmap

The Ethereum 2.0 Roadmap mainly includes three steps: the Beacon Chain, the Merge, and Sharding. The first two steps aim to transition the entire network's consensus mechanism from PoW to PoS (Proof of Stake), while the last step is intended to improve the overall performance of the Ethereum network and enhance scalability.

1. Beacon Chain

To achieve a smooth transition of the consensus mechanism, on December 1, 2020, Ethereum launched a parallel chain called the Beacon Chain while the current PoW mainnet was still running. The Beacon Chain uses PoS as its consensus mechanism and operates independently of the mainnet. Participants need to stake 32 ETH to a smart contract on the chain as proof of stake, and after review, they enter the validator list to become validators of the Beacon Chain. On this chain, validators replace miners and become the builders of the chain.

Under the PoW mechanism, nodes generate the next block through mining calculations, while in the PoS mechanism of the Beacon Chain, the next block is produced by validators who are randomly selected. This selection process is random and not determined by a single validator, reflecting the characteristics of decentralization. Validators who perform well can earn rewards, while those who act maliciously will have a portion deducted from their staked 32 ETH. If their staked ETH falls below 16, they will be removed from the validator list.

Before the Merge, which is the current phase, Ethereum is in a PoW + PoS parallel operation stage. The early activation of the PoS parallel chain is primarily due to two considerations: first, to minimize the impact on the currently running PoW chain and reduce the shock of the consensus transition on the network; second, to give the new PoS network enough time to accumulate staked ETH to ensure the secure operation of the network.

2. Merge

The Merge, often mentioned in discussions about Ethereum 2.0, refers to the merging of the PoW mainnet (referred to as the execution layer for processing transactions) with the PoS Beacon Chain (officially referred to as the consensus layer). The Merge requires testing on the testnet first, and if any issues are found during testing, nodes will make repairs as necessary.

Currently, Ethereum's testnets Ropsten and Sepolia completed the Merge on June 9 and July 6, respectively. The remaining Goerli testnet will also undergo the Merge soon. If all goes well, the Ethereum mainnet will complete the Merge in mid to late September. After that, the PoW mechanism will be abandoned, and the entire network will produce new blocks through PoS.

To ensure the successful switch of the consensus mechanism, Ethereum developers proposed implementing a difficulty bomb to increase the mining difficulty of PoW. The difficulty bomb was added to the Ethereum code in 2015 and is described as: increasing the difficulty of the puzzles in the PoW algorithm at a predetermined block number, making it take longer to produce blocks and making mining more difficult, thereby reducing miners' rewards and discouraging their enthusiasm. Once the difficulty bomb is implemented, miners will become unprofitable, and the original PoW network will no longer be able to continue operating.

3. Sharding

The transition of the consensus mechanism alone cannot enhance Ethereum's performance; performance improvements need to be achieved through sharding. Sharding is a database partitioning concept used to optimize storage and process quickly by dividing the network into smaller partitions, horizontally splitting the database, and distributing the load. Each shard has its own independent data, and multiple shards can process in parallel, thereby reducing network congestion and increasing TPS, achieving network scalability.

Ethereum's earlier sharding plan was to divide the mainnet into 64 shards, each with its own independent block proposer and committee. The block proposer and committee are randomly selected and assigned, with the block proposer selecting transactions from the transaction pool to include in the block. Once two-thirds of the committee agrees, the block can be added to the chain.

This early sharding scheme aimed to expand the performance of the Ethereum main chain. However, it is complex to execute, and with the rapid development of Layer 2 and the flourishing of Rollups over the years, Ethereum developers, centered around Vitalik, have gradually abandoned this original plan in favor of a new technical choice. Instead of directly sharding the Ethereum mainnet to accommodate more transactions, they shifted to a Rollup-centric approach, where Rollups expand at the transaction level, and the main chain only provides data availability for Rollups.

In the new plan, Ethereum aims to serve as a scalable data availability layer, which can be simply understood as the final settlement and accounting. The main chain's scalability will focus on expanding the data capacity of blocks rather than improving on-chain computational efficiency. Specifically, Ethereum's sharding aims to provide more data blobs (binary large objects) space to support Rollups. Ethereum does not need to interpret this data but only collects the computation and proof results from Rollups to ensure data availability, while more computational execution and transaction validity will be handled by Layer 2 Rollups. More specifically, Rollups will perform transaction computation and validation, bundling multiple completed transactions and proof results into a package, while the blocks on the main chain will only record these packages.

Since a block can include multiple packages generated by Rollups, there will be various Rollups on Ethereum in the future to execute scalability for the entire network. Currently, the mainstream ones are zkRollup and Optimistic Rollup, corresponding to validity proofs and fraud proofs, respectively.

Impact of Ethereum 2.0 Upgrade

Reduced Energy Consumption

After switching to the PoS mechanism, the entire network no longer relies on energy-consuming mining nodes, making it more environmentally friendly. The energy efficiency of nodes under PoS is over 99% higher than that of PoW, so the energy efficiency of the PoS network will be greatly improved. When using the PoW mechanism, mining nodes require powerful and energy-intensive hardware to perform complex mathematical calculations. The first to complete the calculation qualifies to build the block and receive the block reward. In this case, miners can only run their mining equipment at full capacity 24 hours a day to maximize profits, and these high-energy-consuming devices undoubtedly have a huge demand for electricity.

In a PoS network, the block proposers are randomly selected, eliminating the need for a large number of mining hardware to compete for block rights, thus no longer requiring massive electricity consumption.

ETH Output

After Ethereum transitions from PoW consensus to PoS, it will no longer generate miner rewards, replaced by staking rewards. Therefore, the issuance rate of ETH will decrease by 90%. This situation is referred to as "Triple Halvening," as it is equivalent to three Bitcoin halvings occurring simultaneously. Ethereum will experience a sudden reduction in issuance, and since staked ETH cannot flow into the market, ETH will enter a deflationary phase.

ETH Staking

After the Merge is completed, more users are expected to choose to stake their ETH, as they can earn a nearly risk-free staking yield. According to estimates, the annual yield for staked ETH is approximately 4%. Kraken's report on "Staking Status in Q1 2022" predicts that after Ethereum completes the Merge, the annual yield for stakers could reach 8.5%-11.5%.

Additionally, due to the increased demand for staking, the staking service sector is expected to experience a surge. Currently, over 13 million ETH are staked on the Beacon Chain, accounting for more than 10% of Ethereum's total supply, with a total of 410,000 validators participating in staking.

Since the network requires a minimum of 32 ETH to be staked, and running node equipment has certain technical and financial barriers, choosing a staking service provider is much more attractive than staking independently. Currently, the leading player in the staking sector, Lido (see the previous discussion on the discount of stETH - pricing, liquidity, and risks of stETH), has captured over 90% of the market share in liquid staking.

Miners

After the Ethereum Merge, the original PoW chain will gradually be phased out, and the fate of the original miners has become an important concern. As the second-largest mining ecosystem in the crypto world, what choices will miners make? Will they choose to fork the original chain or continue mining on ETC? As a fork of Ethereum, Ethereum Classic can use Ethereum mining equipment for mining, but the computing power that Ethereum Classic can accommodate is limited. First, because the price of ETC is relatively low, balancing mining costs and rewards is already challenging, and if a large amount of computing power floods in after the Merge, competition will intensify, further reducing miners' income. Moreover, the forking of the original chain may also be difficult to implement due to the design of the difficulty bomb.

Conclusion

The Ethereum Merge is just around the corner. Although the upgrade plan has gone through several iterations, progress has been generally smooth so far. As the most influential public chain in the blockchain world with the largest number of developers, Ethereum's upgrade will undoubtedly have a significant impact. With the arrival of Ethereum 2.0, the development of public chains enters a new chapter, and the long-standing issues of low performance, high fees, and high energy consumption that have plagued Ethereum users are expected to be resolved through a series of upgrades. We are filled with anticipation for everything that is about to happen.