Ethereum Merge Explained

Adam Lemon

During the second week of September 2022, the Ethereum Merge is taking place, potentially making ETH a more valuable digital asset, improving security for Ethereum blockchain users, and reducing the ETH network's energy consumption by an estimated 99.95%. Read on to find out more.

Ethereum is arguably the world’s most popular blockchain, surpassing Bitcoin in transactions last year for the first time in history. Ethereum’s native token (ETH) is the most widely held and traded altcoin, with over 5.5 million active addresses accounting for over 1.1 transactions each day.

What is the Ethereum Merge?

The Ethereum merge is an enhanced upgrade to the entire Ethereum blockchain which promises to increase overall network security and scalability, massively reduce Ethereum’s environmental impact, and transition the network to a ‘proof-of-stake’ model.

Similar to the Bitcoin blockchain, Ethereum currently implements a ‘proof-of-work’ model, in which an extensive network of nodes (computers sharing a huge network) all compete to solve complex mathematical problems. Network members that solve these problems are rewarded with the ability to mine part of an Ethereum transaction, creating new coins, and accruing a fee.

However, once the Ethereum merge is complete, the new ‘proof-of-stake’ model will select nodes using an algorithm favouring nodes which hold a higher percentage of the ETH currency. In simple terms, the node’s ‘stake’ in the Ethereum network is rewarded as opposed to the current system, which rewards nodes with the most computing power, which has a terrible impact on energy consumption.

How can the Ethereum Merge be Exploited? 

  1. Borrow ETH from DeFi Lending Platforms

In recent weeks, there has been a surge in volume as people borrow ETH from popular DeFi platforms such as Compound and AAVE. This is because the Ethereum network has promised an airdrop to a random selection of ETH holders during the week of the merge upgrade.

Although this airdrop is not guaranteed, a snapshot will be taken prior to the merge, and those who hold ETH (on hardware wallets or exchanges that support PoW forks) may be eligible to earn free tokens.

  1. Proof-of-Work Tokens

If you’re already holding ETH tokens, you will automatically be eligible for the PoW airdrop next week, provided your tokens have been transferred to a hardware wallet or an exchange that supports a proof-of-work fork.

So, suppose you currently store your ETH in a non-custodial wallet or a centralized exchange such as Coinbase or Binance. In that case, your ETH tokens are better stored in a hardware wallet to ensure eligibility requirements are met.

  1. Un-Stake LP / Unwrap any Wrapped Ethereum Tokens

To maximize your eligibility for the upcoming PoW airdrop, it’s recommended to unwrap any ETH tokens that are currently wrapped and add them to your ETH balance in your hardware wallet or exchange-supporting PoW.

Additionally, if you currently have ETH staked alongside another token and it is used to fund a Liquidity Pool (LP), it may be worth un-staking while the merge occurs. Basically, the more ETH you have stored in your hardware wallet, the higher the chance you’ll receive some free ETH tokens as and when the airdrop is released.

However, if your staked LP is accruing interest or rewards, it’s up to you to calculate the risk / reward potential that removing any staked tokens may have as part of your overarching crypto investment strategy. As previously stated, not all ETH holders will receive tokens as part of the airdrop; therefore, any decision to purchase, un-stake, or borrow ETH should be carefully considered.

What are the Risks of the Ethereum Merge? 

  1. Ethereum 2.0 Token Scams

The Ethereum Foundation has pre-emptively issued warnings of scammers attempting to hoodwink investors into believing they need to redeem their ETH for 'ETH2' tokens. However, these tokens do not exist. The name Ethereum 2.0 was initially meant to refer to an upgrade and not the launch of a new network.

As of January 2022, the Ethereum Foundation stopped referring to the upgrade as ETH2 to avoid confusion. To clarify: ETH1 is the ‘execution layer’ which manages transactions and data, and ETH2 is the ‘consensus’ layer that ensures all devices using the network adhere to its rules.

The ETH investors own today will be the same after the Merge. Therefore, current ETH holders do not need to do anything else to keep their funds safe.

  1. Out-of-Work Ethereum and PoW Miners

The massive amount of energy needed to mine Ethereum, and its adverse environmental effect, has long been a contentious issue. It’s one of the primary reasons the cryptocurrency is switching from a Proof-of-Work to a Proof-of-Stake algorithm.

While a greener crypto bodes well for the future, it immediately leaves Ethereum miners with no revenue unless they:

  • Switch to mining Ethereum Classic (ETC); or
  • Use their rigs to mine other cryptocurrencies with compatible algorithms, such as Dogecoin, Litecoin, Monero, etc.

If miners migrate their machines to similar chains, the hash rate on those chains may balloon, decreasing the overall revenue for mining other PoW coins, thus pushing many miners currently using those chains out of business.

  1. The Development of an Alternative Network or Fork

Within the crypto community, there is also talk of creating a fork, i.e., a blockchain split that allows miners to continue a parallel proof-of-work chain (ETHPoW) to protect their income. Its primary advocate, Chandler Guo, a former cryptocurrency miner turned investor and advisor, has even predicted the formation of a dozen PoW forks.

However, given the strong social buy-in for moving to a Proof-of-Stake algorithm and the pervasiveness of assets and tokens stored in DeFi protocols, critics remain sceptical about whether a fork will be worthwhile, especially as the strength of Ethereum has shifted from miners to developers.

  1. Ethereum Volatility

This is the first time a network is transitioning from one consensus to another in crypto history. Naturally, Ethereum’s price may experience short-term volatility, with a move to the downside. There is also the possibility it could lose its market dominance—if a fork does emerge, it may hurt liquidity as investors withdraw ETH tokens for forked ones.

Yet, like any high-risk investment, Ethereum can quickly shift price direction. Although its price action has been bearish during the first eight months of 2022, there is a possibility its price may turn a bullish corner after the merge. Looking at macroeconomic factors such as inflation and government crypto regulations can help shape future investment strategies.

Bottom Line 

The many advantages of the Ethereum Merge will probably eclipse any short-term pitfalls. Undoubtedly, improvements in security and sustainability will unlock Ethereum as a more viable investment option for traditional institutions. Having a cryptocurrency currency with minimal environmental impact can potentially make it a truly scalable and cheaper network to build and invest in, creating an exciting possibility for the future of cryptocurrencies.

Investors and traders should keep in mind, however, that macro factors such as the strength of the US Dollar and broader risk-off sentiment could easily overpower Ethereum over the short-term, meaning any bullish effects of the Merge might not become apparent until after some delay.

FAQs 

Will the price of Ethereum go up after the merge?

It is impossible to say where the price of Ethereum will go after the Merge, but the micro factors induced by the merge are likely to make Ethereum more attractive and efficient so it should be a bullish factor in influencing the price.

What happens to ETH when ETH2 comes out?

ETH will be transferable to ETH2.

Will ETH2 replace ETH?

No, it is a merger, not a replacement – ETH2 is not a separate blockchain.

How does Ethereum 2.0 work?

Ethereum 2.0 differs from Ethereum in that it uses a proof of stake (not work) mechanism.

Adam Lemon

Adam Lemon began his role at DailyForex in 2013 when he was brought in as an in-house Chief Analyst. Adam trades Forex, stocks and other instruments in his own account. Adam believes that it is very possible for retail traders/investors to secure a positive return over time provided they limit their risks, follow trends, and persevere through short-term losing streaks – provided only reputable brokerages are used. He has previously worked within financial markets over a 12-year period, including 6 years with Merrill Lynch.
Learn more from Adam in his free lessons at FX Academy

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