The Impact of Ethereum 2.0
In early 2021, Ethereum crossed more than 1 billion transactions, hosting many of the biggest advancements and applications for decentralized business operations. To this day, it is the most used blockchain ecosystem, powered by the second-largest crypto asset by market capitalization. However, this huge transaction volume has undermined latency, delaying transactions and increasing their costs.
To ensure broader scalability, the Ethereum foundation has started a very ambitious upgrade (seven years in the making), to improve the infrastructure so it can service global financial industries: Ethereum 2.0
Ethereum 2.0 aims to improve three main aspects of the Ethereum network; security, decentralization, and scalability. They proposed two main changes, implementing “Proof of Stake” instead of “Proof of work” and applying “sharding” as a scaling solution.
What exactly are these critical improvements planned with Ethereum 2.0?
(i) security, increasing the cost of attacking the blockchain, and ensuring that, in the extremely rare case of getting attacked, the coordination of a new chain that gets rid of the attacker gets done easily;
(ii) energy efficiency, addressing the rising criticism towards the energy consumption of the most-known blockchain -bitcoin-, the updates guarantee a secure, yet efficient energy usage. With PoS, validators are selected based on the amount of ETH that they have staked (deposited) in the network. Hence, they have an incentive to act honestly (otherwise their stake will be slashed/destroyed). There will no longer be thousands of graphic cards “mining” and competing for the next block, ensuring that there is quasi no energy consumption other than the cost of the servers that run the nodes;
(iii) reducing the risk of centralization from miners, by switching from Proof-of-Work (PoW) to Proof-of-Stake (PoS), Ethereum 2.0 makes sure that participation in the consensus process is virtually accessible to all users. With the current consensus system based on PoW, manufactured centralization is possible, since the larger the hardware infrastructure the cheaper it is to mine.
Currently, Ethereum 2.0 is reaching Phase 1 where 64 shard chains are expected to be launched in 2021. Phase 0 of Ethereum 2.0 was reached after the beacon chain was deployed in December 2020 and Phases 1.5 and 2.0 are expected for the end of the year and by 2022 respectively. Phase 1.5 will be reached when the existing network is merged with the beacon chain and Phase 2.0 will add execution to the shards.
With the release of ETH 2.0 (among other improvements) we’re going to see ETH drastically increase its tx/s and therefore its commercial and consumer viability. Gas clogs, high transaction costs, long wait times in dApps all go away, even in a busy market. Certainly, a great advancement that will improve many of the business cases power by Distributed Ledger Technologies.
The Big Change: “Proof of Stake” Consensus
The current Ethereum network (1.0) uses a “Proof of work” consensus protocol which implies solving a mathematical puzzle that produces the cryptographic link between the current block and the previous block. Miners acting as validators of transactions compete to create new blocks full of processed transactions. The miner that solves the puzzle the fastest shares the new block with the Ethereum network and earns Ether as a reward.
Although it is a good consensus protocol, it requires great computational power. Every miner has the incentive to increase the probability of being elected for mining by increasing their computational power (speed), meaning investing in GPUs and creating mining farms that discourage the Ethereum network.
As a solution, the “Proof of Stake” consensus protocol proposed for Ethereum 2.0, establishes a minimum stake in ETH to participate as a validator (32ETH). With this, participating validators are chosen randomly to create new blocks and share them with the Ethereum network (Ethereum, 2020). “The total stake for the selection of each block proposer will consist of the sum of self-stake and the stake delegated from other token holders” (Blandon, 2020). This aims to improve the decentralization of the Ethereum network and the energy consumption efficiency.
The consensus mechanism “Proof of Stake” is secured by the fact that an attacker would need 51% of the total staked ETH to defraud the chain and the attacker’s stake would be reduced for malicious behavior. The risk of an attack is reduced as there is a higher probability of losing the stake.
Scalability: Ensuring An Agnostic Network
The second main change in Ethereum targets scalability. In order to increase the transaction and database speed, there is a second layer that handles transactions off the main Ethereum chain (Layer 1). The beacon chain (coordination layer) allows people to “stake” and coordinate the validators on the platform and the Shard chain (data layer) splits the database horizontally increasing the capacity to store and access data (from 15 transactions per second to more than 2,000 TPS).
Ethereum is implementing Optimistic Rollups as a scaling solution due to its compatibility to Ethereum Virtual Machine (EVM) and Ethereum smart contracts (Ethereum, 2021b), aiming to reduce fees for users, encouraging open participation, and allowing faster transaction throughput. For a more detailed explanation see “New on the chain: Ethereum 2.0, a competitive blockchain for all businesses”.
Addressing The Elephant In The Room: Increasing Gas Fees
In addition to Ethereum 2.0 phases, the Ethereum network is expecting the integration of Ethereum Improvement Proposal (EIP) 1559 in July, where the Ethereum pricing model will change.
Currently, there are two sources of income for miners: the gas fees associated with transactions and the rewards for creating blocks, being the first one the most profitable due to its structure. A user making a transaction proposes (the maximum price a user is willing to pay) a gas fee that will cover the computational power and will work as an incentive for miners to pick up the transaction faster and on the other side miners decide which transactions to include in their block (Ethereum, 2021a). This process is a simple auction that naturally increases the fees and, if there is no upper bound, users can be affected especially when there is congestion in the Ethereum network.
Imagine creating a Security Token Offering with an underlying asset as stocks. The offering would have a specific price that will include the transactions and processes associated with it (e.g. Smart contract, account balance). After it is issued, investors will create new transactions (buying or selling security tokens) that will carry different gas prices. Investment transactions would be subject to the gas fee and the security token price in the market with an increasing price volatility risk in the gas fee. The preceding assuming the investor knows how to set a fair price.
Research made by Werner et al. (2020) demonstrated how gas fees were mispriced, and they proposed a novel mechanism for users combining deep learning and an algorithm parameterized by a user-specific urgency value to recommend gas prices. In this study, costs were saved by more than 50% with an inclusion delay of only 1.3 blocks.
EIP 1559 would improve the user (e.g. investor) experience by setting a base fee and a maximum price increase/decrease of 12.5% per block (Jakub, 2020), limiting the prices’ volatility.
EIP 1559 proposes two fees: a base fee that will change depending on how congested the network is and an inclusion fee dedicated to miners. This provides an opportunity for the Ethereum network which is growing due to Decentralized finance (DeFi). Stable prices increase economic agents’ participation and with it the increase of Ether price. As stated by Sabalionis et al. (2020), the Ether price is significantly affected by the amount of active addresses in the Ethereum network. And if we add this to the expected Ethereum scalability, there is a promising sustainable framework for business.
In contrast, this is terrible news from the miners’ point of view. The new integration will mean miners will only receive the block reward plus the inclusion fee decreasing their earnings significantly. In addition, the base fee will be burned, meaning that less Ether will be in the market (supply reduction). Currently, ETH supply expands according to demand (bitrates, 2017) which makes it subject to abrupt inflation/deflation. Burning base fees is a tool to control the inflation/deflation issue in the Ethereum network, and it must be tested with precaution to avoid unnecessary movements in price.
According to Grayscale and many others, burning will generate ETH to rise, which is true at some point. However, the total supply still will increase and part of it will be burned, —1-4% per year (Genc, 2021)—, meaning there will be a small increase in price due to burning and most of the price increase would be related to the increasing demand for ETH. In the end, EIP 1559 will have a good impact in the long term if miners are willing to reduce their fees in the short term and if base fees are periodically reviewed.
Use Case: Integrating Ethereum 2.0 Improvements & Benefits into micobo’s Enterprise Tokenization Solution
micobo’s clients will benefit from Ethereum network developments thanks to the reduced costs per transaction, the scalability of the Ethereum network, security, and their stability.
micobo’ Security Token Offering uses ERC20 and ERC1400 compatible standard smart contracts that will logically benefit from a solid and scalable network. On one side, transactions will be validated faster due to the scalability implementations, continuing with the decentralization of the Ethereum network and the energy consumption efficiency (which goes along with the Environmental, Social and Governance-ESG goals). On the other side, with EIP 1559 integration, wallets do not have to estimate gas fees anymore. Instead, wallets can set the gas fee automatically and changes in gas fees can be predictable, improving the investors’ experience in micobo’s platform.
Gas fees will be fair depending on market conditions so that investors and issuers will save costs when there is low activity in the Ethereum network. Additionally, for ETH holders, the expectation is to increase in the short and long term.
micobo GmbH is a leading European software company for Security Token Offerings and Blockchain Software Development (DLT). It provides fully compliant software solutions for Security Token Offerings and advises on structuring DLT- and Blockchain-based Securities. micobo empowers financial institutions with state-of-the-art technology focusing on providing a better customer experience and achieving measurable results.
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