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Ethereum merge: What is it and how will it impact your ether holdings?

Watch: The Crypto Mile: Episode 6 - Ethereum insider reveals consequences of 'the merge'

The Ethereum (ETH-USD) 'merge' has been hailed as a success by the blockchain's co-founder Vitalik Buterin. The major upgrade could now make the supply of ether "continuously reduce over time", which could then lead to a spike in the value of the cryptocurrency.

What is the merge, and how will it impact your ether holdings?

In Episode 6 of The Crypto Mile, core researcher at the Ethereum Foundation Dankrad Feist explained the reasons behind the long-awaited update and its impact on the entire cryptocurrency ecosystem.

Read more: Crypto live prices

After the 'merge' was finalised on Thursday, Ethereum's native cryptocurrency ether rose in value to $1,638, up almost 2% in the past 24 hours.

Bitcoin (BTC-USD) also increased in value, up by 5.3% in the past seven days, to $20,298 as of the time of writing.

1. What is the merge?

The world's first "smart contract" blockchain has just completed one of the most important upgrades in its history and is now about to go through a series of upgrades that will ensure that it becomes more environmentally friendly, more secure, and more scalable.

The first upgrade happened on Thursday and was called 'the merge'. This successful update means that transactions on the Ethereum blockchain are now validated by the more environmentally friendly proof of stake validator nodes.

In order to become a validator node, investors "stake", or lock up, 32 ether. Validators then receive interest on their staked coins as a reward for their active participation in the network.

Ether tokens will remain exactly the same for investors after the merge, and there should be no change to the operations of Ethereum-based applications.

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 means that "all the applications running on the old Ethereum blockchain will be put on the new chain, the proof of stake chain".

Proof of work 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

Read more: Ethereum supply to shrink after 'Merge' upgrade, says Vitalik Buterin

"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."

2. Why it is being done now and what comes next?

Ethereum's merge is one of several upgrades that have been scheduled for the continued development of the world's second-largest blockchain as it evolves into Eth 2.0. The steps towards Eth 2.0 include the merge, surge, verge, purge, and splurge.

Last week a preliminary upgrade known as the Bellatrix upgrade was successful. Ethereum's co-founder Vitalik Buterin tweeted: "The Merge is still expected to happen around Sep 13-15.

"What’s happening today is the Bellatrix hard fork, which *prepares* the chain for the merge.

"Still important though — make sure to update your clients!"

Now that the merge is complete, developers will aim to expand Ethereum’s transaction throughput and decrease its fees by spreading network activity across several “shards”, this upgrade is called the surge.

Next will come 'the verge', which will allow more people to become Ethereum network validators, something Buterin suggests will help decentralisation and network security in the long term.

This upgrade will be followed by the purge, which will make the history recorded on the blockchain more streamlined, and the splurge, which Buterin gave scant information about, other than it contains “all of the other fun stuff.”

DENVER, CO - FEBRUARY 18: Ethereum co-founder Vitalik Buterin speaks at ETHDenver on February 18, 2022 in Denver, Colorado. ETHDenver is the largest and longest running Ethereum Blockchain event in the world with more than 15,000 cryptocurrency devotees attending the weeklong meetup. (Photo by Michael Ciaglo/Getty Images)
Ethereum co-founder Vitalik Buterin. Photo: Michael Ciaglo/Getty

3. How will it impact investors who hold ether and other cryptocurrencies?

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 ether a deflationary digital asset.

Read more: Ethereum: Two glimmers of hope for crypto investors as crash stabilises

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.

Now that the blockchain has switched to a proof of stake consensus mechanism, this will stop. So, the merge "could in some ways benefit the value of ether potentially and make it a better coin to hold," according to Feist.

The developer 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 even wish to invest in the Ethereum network via staking pools, according to Feist.

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 springboard 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.

Read more: The flippening? Ether overtakes bitcoin in options market for first-time

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 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.

Representation of Ethereum, with its native cryptocurrency ether, is seen in this illustration taken November 29, 2021. REUTERS/Dado Ruvic/Illustration
The Ethereum merge could make 2022 a 'make-or-break' year for the world's second-largest cryptocurrency by market cap. Photo: Dado Ruvic/Reuters

4. The impact of the merge on the nascent Web3 economy

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.

However, the impact of the merge will be felt by every sector of the crypto-industry, including bitcoin.

Ethereum's decision to ditch the energy-intensive proof of work consensus mechanism will isolate bitcoin.

The blockchain that started the whole industry will be isolated from the rest of the blue-chip cryptocurrencies, which are now mostly operating in a more environmentally friendly way.

However, this may not put pressure on the bitcoin community to transition to proof of stake as sentiment among bitcoin advocates is that proof of work is more robust to the risks of centralisation and censorship attacks from state-ordered regulation.

NEW YORK, NEW YORK - SEPTEMBER 06: People walk past the  the New York Stock Exchange before the start of morning trading on September 06, 2022 in New York City. President of Ukraine Volodymyr Zelensky delivered a message before the ringing of the opening bell to highlight the launch of Advantage Ukraine, an initiative aimed at driving foreign direct investment in Ukraine, as stocks fell to open the week of trading.  (Photo by Michael M. Santiago/Getty Images)
Analysts predict that a successful upgrade will make the Ethereum blockchain more attractive to inward investment from institutional finance. Photo: Michael M. Santiago/Getty

5. Who are the top institutional holders of ethereum?

Analysts predict that 'the merge' will make the Ethereum blockchain more attractive to inward investment from institutional finance, who will see it as a safer option when considering their ESG obligations.

The Ethereum blockchain is the bedrock that powers decentralised finance (DeFi) and so may have long-term value for institutions.

The head of the US Security Exchange Commission (SEC) Gary Gensler suggested on CNBC that both ethereum and bitcoin will not be categorised as securities. This means ethereum will not be exposed to regulatory risks that institutional finance would want to avoid.

Bitcoin has already drawn the interest of major asset managers such as BlackRock (BLK) and Fidelity (FNF) and now interest in ether derivatives is surging amid the countdown to the merge.

On Tuesday, CME Group (CME) launched options on ether futures as planned, with each ether futures contract sized at 50 ether.

They are based on the CME CF Ether-Dollar Reference Rate, which serves as a once-a-day reference rate for the US dollar price of ether.

SEBA bank has created a fully regulated banking service that gives its clients institutional access to ethereum staking.

Head of research at CoinShares James Butterfill said: "Ethereum saw inflows totalling $16m and is enjoying a near seven consecutive week run of inflows totalling $159m.

"We believe this turn-around in investor sentiment is due to greater clarity on the timing of the merge."

The largest institutional holders of ethereum, through the Grayscale Ethereum Trust (ETHE), are Monolith Advisors, Hancock Whitney Corp (HWC) and the Canal Insurance Company.

Watch: Working for a DAO: 'No boardroom, no boss, no bias' | The Crypto Mile