The Ethereum "merge" will see the supply of ether "continuously reduce over time", which could lead to a spike in the value of the cryptocurrency.
In Episode 6 of The Crypto Mile, core researcher at the Ethereum Foundation Dankrad Feist explains the reasons behind the long-awaited update and its impact on the cryptocurrency ecosystem.
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On Wednesday, ethereum (USD-ETH) rose in value by 5.2%, reversing a six-day straight decline and pushing ethereum to $1,655 — up 15.1% in one week.
Bitcoin (USD-BTC) also increased in value, up by 2.9% in 24 hours, to $23,380 as of the time of writing.
The upcoming Ethereum 'merge' to a proof of stake
The world's first "smart contract" blockchain is about to go through a series of upgrades that could make it more environmentally friendly, more secure, and more scalable.
As a revolutionary technology that promises to be the foundation layer of web3, Ethereum is not yet finished, and at this year's Ethereum Community Conference in Paris, co-founder Vitalik Buterin stated the upcoming "merge" will only make Ethereum 55% complete.
Ethereum researcher Dankrad Feist described the "merge" as the coming together of two chains — the beacon chain, which is currently running on the proof of stake consensus mechanism, and the legacy main ethereum blockchain, which up until the merge has been using a proof of work method.
Feist said the "merge" will mean "all the applications running on the old Ethereum blockchain will be put on the new chain, the proof of stake chain".
The difference between proof of work and proof of stake is that the former uses "mining" to validate transactions on the blockchain, whereas proof of stake uses "staking".
"Proof of work mining is the algorithm that uses lots of computers to solve certain cryptographic puzzles in order to create blocks, this is how bitcoin and ethereum are currently secured, but there are huge environmental problems created by 'proof of work' because it consumes a massive amount of energy, and so it uses a massive amount of CO2," said Feist
"However, proof of stake uses a different kind of algorithm, that is currently used by certain other blockchains, but wasn't available when ethereum was created.
"Proof of stake does not rely on this waste of resources, instead it creates security by locking ethereum up, and this ensures the security of ethereum.
"The great thing is that this gets rid of the massive wastage of power from proof of stake, but that it is also a much more secure algorithm, by paying less money to the 'stakers' and becoming much more secure at the same time."
The "merge" is set to happen in September and will see Ethereum make a full transition from the high energy intensive "proof of work" method to a low energy use 'proof of stake'.
The impact of Ethereum's 'merge' on the price of ether
The Ethereum "merge" could make 2022 a "make-or-break" year for the world's second-largest cryptocurrency by market cap, and certain factors involved in the update will make the blockchain's native cryptocurrency, called ether, a deflationary digital asset.
Miners who run validation nodes for the current "proof of work" mechanism are paid around 5% of the total issuance of the cryptocurrency every year. This has made the cryptocurrency inflate by about 4.5% annually.
This will stop after the "merge", and this "could in some ways benefit the value of ether potentially and make it a better coin to hold," according to Feist.
Feist added: "In proof of stake, the new issuance will be cut by a factor of ten and taking into account the burn, issuance will actually be negative and more ethereum will be burned than issued in the future leading to ethereum's supply continuously reducing over time".
The move to "proof of stake" should appeal to institutional finance which is wary of the environmental, social, and governance (ESG) implications of the carbon-intensive "proof of work" method used for bitcoin transactions.
Institutional finance may wish to invest in the Ethereum network via "staking" pools and the upgrade could have significant implications for the price of ether, according to Feist.
Ethereum flipping bitcoin in market cap rankings
The "merge" has generated excitement amongst traders, with retail investors pouring in disposable income in the run-up to September's upgrade.
There is a sense that it could spring-board Ethereum to the next level of mass adoption, pending the success of the upgrade.
Many professional traders are also factoring in a post-merge price hike by placing put options to buy the cryptocurrency at a lower price in future months, signalling that they expect a significant value appreciation.
A move to a less energy-intensive "proof of stake" mechanism for validating transactions is welcome as the upgrade will also make transactions on the blockchain more efficient.
It will also be welcomed by a planet spiralling into a runaway climate crisis as the legacy "proof of work" method, where transactions can sometimes emit the same amount of carbon as a short-haul flight is becoming less and less palatable.