Detailed progress of the Ethereum merge and the MEV and miners after the merge

Written by: Amber Group

Compiled by: ChinaDeFi

Summary

• The merge significantly changes Ethereum's monetary policy, reducing Ethereum issuance by about 90%. Within 6-12 months, the principal of validators (32 ETH) and newly issued ETH will lack liquidity and will be "stuck" on the beacon chain. The deflationary monetary policy and increased demand for staked ETH may lead to a significant contraction in the circulating supply of ETH.
• Comments from the Ethereum community suggest a soft target for the merge in September. A series of market indicators show that the market expects the merge to occur at least by the end of the year. Binance's rate pricing indicates that the market expects the merge to happen before the end of September.
• Ethereum MEV will change after the merge. Most validators will run MEV-boost—a free open-source software that democratizes the acquisition of MEV rewards. However, due to several factors (MEV smoothing, multi-block MEV potential, DoS mitigation), validator pools and centralized entities may continue to gain validator market share in the short term. Ethereum developers are working on solutions to address this issue at the protocol level.
• Since Ethereum's inception, miners have been a key component of Ethereum. It is difficult to "kick" them out. The largest GPU-mineable blockchain, Ethereum Classic, cannot cope with the influx of Ethereum hash power after the merge. Due to the lack of alternatives, some miners have expressed support for the ETHPoW fork. We expect the fork may generate a lot of headlines, but its long-term value may be negligible.

Introduction

The merge is approaching. Ethereum will transition from proof of work to proof of stake while enhancing its security and sustainability. However, questions remain about what the merge actually does, how it affects various stakeholders, and when it will actually arrive. This report covers the current state of the merge, key impacts before and after the merge, and a range of measures to gauge market sentiment.

Current State of the Merge

Two live testnets, Ropsten and Sepolia, have successfully merged. Additionally, there are ten shadow forks on the mainnet that have been fundamentally successful. These practice runs have exposed several minor bugs, most of which have been fixed. Goerli will be the last testnet to merge, expected to take place around August 6 to 12.

If all goes well, the mainnet merge is expected to occur during the week of September 19. However, this is not a definitive date. The timeline proposed by Tim Beiko in the Ethereum consensus layer call is a soft target, not a final goal. Additionally, estimating the merge time is difficult. On the testnets, the speed of merge activation has been faster than expected. Nevertheless, the timeline proposed below can serve as a good rough approximation.

Source: Call #91 of PoS Implementers

What the Merge Can and Cannot Do

The merge will not significantly increase transaction throughput or reduce gas fees. It merely changes the consensus mechanism from proof of work (PoW) to proof of stake (PoS). Other conditions being equal, gas fees will slightly decrease as block production speed increases from about 13 seconds to 12 seconds.

Staked ETH after the merge cannot be withdrawn. The Shanghai hard fork is expected to launch within 6-12 months after the merge, allowing for the withdrawal of staked ETH and the issuance of new ETH on the beacon chain only after the fork occurs. However, transaction fees and MEV fees will flow immediately after the merge. We will clarify how withdrawals will work later in this report.

The merge does not support on-chain governance. Some PoS blockchains have on-chain governance, where rules and upgrades are governed through some form of on-chain voting (e.g., Cosmos and Polkadot). But Ethereum after the merge is not like that. Similar to Bitcoin or the current version of Ethereum, protocol changes are discussed and decided off-chain by a broad base of stakers.

The merge does not mean that stakers can obtain funds for free. Under PoW, the Ethereum protocol must provide sufficient incentives to compensate miners for their operating costs and allow them to make a slim profit. A common view is that by transitioning to PoS, validators have almost no ongoing costs, allowing stakers to easily enjoy high returns.

But staking is not free. Compared to other ETH yields, validators face capital opportunity costs when choosing to invest funds in ETH and stake their ETH on the beacon chain. If staking were free, people would continuously acquire and hold more capital until reaching a similar equilibrium. In fact, this situation has already occurred in the stETH leveraged trades that were closed in May and June.

The merge significantly changes Ethereum's monetary policy. Ethereum is currently rewarding miners on the beacon chain (at a rate of 2 ETH per block) and validators. After the merge, rewards for miners will cease, leading to a reduction in ETH issuance of about 90%, referred to as the "triple halving."

The merge greatly reduces Ethereum's energy consumption and carbon emissions. Under PoW, entities need to purchase energy-intensive mining equipment to secure the Ethereum network, leading to high electricity consumption and hardware waste. Ethereum's current energy consumption is comparable to that of Chile; its carbon footprint is similar to that of Hong Kong.

After the merge, entities staking collateral will ensure network security. There will no longer be competition for acquiring more powerful mining equipment, significantly reducing energy expenditures. Most forecasts indicate that Ethereum's energy consumption will decrease by over 99.95%.

Projected annual energy consumption (TWh/yr) Source: Ethereum.org, Digiconomist

Key Points - Critical Areas

"Triple Halving"

This merge is expected to significantly change the capital flow in and out of the Ethereum ecosystem.

In terms of supply, Ethereum is currently incentivizing miners (under PoW) and validators (under PoS). Miners produce new blocks at a rate of 2 ETH per block, receiving the minting tax, which is also distributed to validators on the beacon chain. After the merge, rewards for miners will stop, and Ethereum's issuance will decrease by about 90%. This is why this merge is colloquially referred to as the "triple halving"—a nod to Bitcoin's halving cycles.

Ethereum can reduce ETH issuance because PoS is a more efficient way to secure the network compared to PoW. Under PoW, Ethereum needs to issue enough ETH to cover miners' costs (buying mining equipment and paying for electricity) and provide a slim profit. Under PoS, Ethereum only needs to pay the opportunity cost of the funds. Additionally, PoW can only incentivize good behavior among miners through rewards, while PoS also allows Ethereum to curb misconduct through slashing.

Ethereum Will Experience Deflation After the Merge

Source: Ultrasound.money

Due to various factors, demand for Ethereum is also expected to increase after the merge. First, staking rewards for validators will increase immediately. Validators will receive transaction fees currently earned by PoW miners, potentially raising the APR by about 2-4%. Additionally, as they can reorder transactions, they will also start earning MEV (maximum extractable value). Researchers from Flashbots, an organization studying MEV burst behavior, state that due to MEV (assuming 8 million staked ETH), validators' yields could increase by an additional 60%. Therefore, if the merge were to happen today, validators could expect a total annual yield of about 8-12% due to all the factors mentioned above.

Total Staking Yield If the Merge Occurs Today

Source: @StakeETH, @eth2calculator, Etherscan, Beaconcha, Flashbots

Note: The estimate of MEV rewards is conservative, as it is a lower bound estimate from Flashbots.

Of course, such yields are unsustainable. Therefore, we expect that the amount of staked ETH will significantly increase after the merge. If the proportion of staked ETH to total ETH is comparable to alternative L1s (Solana and Tezos: 75%, Cosmos: 64%, NEAR: 39%), then Ethereum's staking yield will compress to below 2% annualized.

Sensitivity Analysis of Total Staking Yield After the Merge

Source: @StakeETH, @eth2calculator, Etherscan, Beaconcha, Flashbots

Other factors expected to affect ETH supply and demand include:

• After successfully transitioning from PoW to PoS, ETH reduces its risk.
• Eliminating criticism of energy use, network energy expenditures will decrease by 99%.
• Due to its staking returns, Ethereum will increasingly be viewed as a financial instrument, akin to equity or perpetual bonds.
• Withdrawals from the beacon chain will not be enabled until after the Shanghai hard fork, expected to launch within 6-12 months after the merge.

Shanghai Hard Fork

The issue of withdrawing staked ETH on the beacon chain is often misunderstood. Withdrawals of staked ETH and issuance of new ETH will not be enabled at the time of the merge. Instead, it will be enabled in the Shanghai upgrade, tentatively scheduled for 6-12 months after the merge.

However, priority fees and MEV fees (which may account for more than half of total staking rewards) can be withdrawn immediately after the merge.

Capital Outflow After the Merge?

The Shanghai hard fork will allow for two separate types of withdrawals. The first is partial withdrawals—allowing active validators to withdraw accumulated rewards and reduce their staking balance to 32 ETH. These are significant because they allow validators to withdraw their generated income without fully shutting down and reactivating their validator. It also allows validators to maximize efficiency, as excess tokens beyond 32 ETH are inefficient. If partial funds are not withdrawn, earned rewards will become idle capital.

The maximum number of partial withdrawals per epoch is currently set at 256. With 225 epochs per day, this means that 57,600 validators can withdraw their rewards daily. Currently, the average balance of all active validators is 33.66 ETH. We can expect this number to rise to around 34 ETH at the time of the Shanghai upgrade, indicating that partial withdrawals will occur in the market:

(34-32) x (57600) = 115200 ETH / day

(If ETH = $1500, approximately $173 million)

This could last from 7 days (based on the current 410k validator set) to 14 days (if the validator set increases to 800k).

Validators can choose to withdraw the full amount. To ensure the security of the Ethereum network, full withdrawals and withdrawals per epoch are limited, currently set to about 6 per epoch. If all currently active validators wish to withdraw, it would take over a year.

We expect that most of the rewards obtained from partial withdrawals will create new validators rather than being sold to the market, and that demand for new deposits will exceed the potential selling pressure from full withdrawals. Nevertheless, we point out this dynamic because it operates differently from how PoS-based blockchain networks function and could cause confusion.

Outcomes

• ETH issuance will decrease by about 90%.
• Within 6 months to 1 year, the principal of validators (32 ETH) and issuance rewards will lack liquidity and be stuck on the beacon chain.
• Through deflationary monetary policy and demand for staked ETH, the circulating supply of ETH may continue to decrease.

Building Blocks

MEV has evolved from a niche topic a few years ago to a focal point of blockchain research today. MEV affects all areas of blockchain. The full impact of MEV is beyond the scope of this report, so we will briefly introduce how MEV will affect validators after the merge.

Maximum Extractable Value (MEV) broadly refers to the total amount that miners or validators can increase their balance over a series of blocks given available operations. These operations can include reordering transactions, reviewing blocks, and even attempting to reorganize the chain. Some common forms of MEV include sandwich attacks, arbitrage, and liquidation.

History and Current State of MEV

In Ethereum's current state, most users send their transactions to the public mempool via wallets. Searchers continuously monitor the mempool for potential profit opportunities. In the early days of MEV, searchers captured these opportunities by bidding high gas prices to gain transaction priority.

As MEV became more competitive, priority gas auctions (PGA) emerged, increasing network load, leading to gas price volatility, inefficient use of block space, and other issues. Other negative externalities also began to emerge. Teams started building infrastructure globally to provide faster and broader access to various mempools. Services provided by miners allowed searchers to bypass the public mempool and execute transactions privately.

Several solutions have emerged to mitigate these negative externalities, with Flashbots being the most prominent.

These solutions have largely democratized MEV. Searchers discovering unique MEV opportunities can avoid revealing their strategies to other searchers and capture most of the profits. For more competitive strategies (like arbitrage), miners earn MEV revenue through bids submitted by searchers.

MEV After the Merge

After the merge, validators will replace miners. However, there is no built-in mechanism at the protocol level to help validators capture MEV. If left unchecked, this structure will allow professional firms and larger entities to better capture MEV by setting up multiple validators and constructing optimal blocks. Other validators will struggle to compete effectively.

Fortunately, Flashbots has also created a post-merge alternative called MEV-boost. MEV-boost allows validators to auction their block space to the open market and maximize their staking rewards.

MEV Supply Chain

Source: Flashbots

In this framework, searchers will continue to seek profit opportunities from MEV and bid for their bundles to be included. Builders aggregate all these bundles to construct the best complete block that pays the highest. When it is a validator's turn to propose a block, they query the MEV-Boost relay for the highest-paying payload and include it in their proposed block.

However, MEV rewards will vary. For example, high volatility periods often bring higher MEV fees. Validators proposing during these periods may receive higher MEV rewards. A study by Flashbots last year confirmed that considering MEV factors exacerbates inequality among validators.

Inequality Between Validators Without MEV (Left) and With MEV (Right)

Source: Flashbots

Note that the distance between the green and red lines widens significantly with MEV extraction.

Thus, large institutions and validator pools that can socialize/smooth MEV by running thousands of validators will benefit from this. This dynamic is similar to why GPU miners join mining pools while working from home—stability and predictability of income. The potential for multi-block MEV is a further source of power.

Validator Allocation in Staking Pools

Source: Beaconcha.in

Until Ethereum builds MEV smoothing into the protocol layer (which is currently in progress), validator pools and centralized entities may continue to gain market share.

Miners, Forks, etc.

Miners are an important part of the Ethereum ecosystem. They have spent about $15 billion on GPUs in total. After the merge, all their equipment and infrastructure will be idle and need to find alternative uses. Anticipating the merge, the resale price of GPUs has already dropped by half compared to the beginning of this year.

Therefore, what miners will do before and after the merge remains highly uncertain. Some behaviors that could be described as antagonistic have been observed. In May of this year, before the launch of the Ropsten beacon chain, a miner significantly increased their hash rate to reach TTD, forcing developers to retest the merge on Ropsten.

In the miner's words, the reason for doing this was: "This is a stress test for the ROPSTEN network to see what happens if the merge goes beyond plan."

Miner-Induced Sudden Surge in Ropsten Hash Rate

Source: bordel.wtf

Before the merge, miners' reactions may be even more intense, severely degrading the user experience on Ethereum.

For example, miners could steal MEV. When searchers send bundles to miners via Flashbots, they trust that miners will not steal/expose/corner the market. As the merge approaches, miners could start doing this as the cost of being caught decreases.

Theoretically, miners could also begin running clients to reorganize the Ethereum blockchain to retroactively capture MEV. These tools have been proposed in the past but have largely faced community opposition. Large mining pools have not adopted them, primarily to protect their reputation and avoid harming the Ethereum network.

Source: @ethermine_org

We hope that the largest mining pools, like Ethermine, will not engage in malicious behavior. F2pool, the second-largest mining pool globally, merged with its sister company Stakefish long ago. Ethermine has also launched a beta version of its staking pool service.

Nevertheless, smaller miners may attempt to squeeze as much income as possible through malicious behavior before the merge.

Where Will Miners Go?

After the merge, if these machines attempt to operate within the crypto ecosystem, the most likely candidate is Ethereum Classic, which is a fork of Ethereum resulting from the 2016 DAO hack. Just this week, the eighth-largest Ethereum mining pool, Antpool, pledged to invest $10 million in developing the Ethereum Classic ecosystem.

However, Ethereum Classic's daily fees are several orders of magnitude smaller than Ethereum's. Furthermore, if miners heavily utilize GPU hash rates, especially without price increases, the profitability of mining these networks will inevitably decline.

GPU-Mineable Blockchains

Clearly, other GPU-mineable blockchains cannot handle the large number of idle GPUs after the merge. Additionally, Bitpro estimates that for GPU miners to remain profitable in the crypto ecosystem, about 95% of GPUs need to be shut down. This scenario is unlikely to happen immediately after the merge.

Therefore, miners may attempt to maintain a PoW fork after the merge. Some miners have already expressed support for the ETHPoW fork. If some exchanges support the fork and a small group of miners continues to use it, the fork's lifespan may be longer than expected.

Even if this happens, almost all users and developers will stick with the standard PoS Ethereum. The ETHPoW fork lacks any meaningful philosophical or ideological support. Moreover, the Ethereum ecosystem today is vastly different from 2016 (when the ETH/ETC fork occurred). Real-world asset issuers, such as Circle (USDC) and Tether (USDT), will only support minting/redeeming on the standard chain. Wrapped assets (like wBTC) will also do the same. L2s and bridges will only support assets bridged from the main chain. DeFi on the ETHPoW fork becomes a strange existence, with billions of assets potentially rendered useless overnight.

Thus, we expect the fork may generate a lot of headlines, but its long-term value may be negligible.

Pricing?

Liquid Staking Derivatives

Liquid staking derivatives can serve as a measure of market sentiment. The three largest are Lido (stETH), Binance (bETH), and Rocket Pool (rETH).

stETH and bETH are adjusting their token bases—the ratio of token balance to ETH is 1:1, and the token balance is updated periodically to reflect rewards. Therefore, after the Shanghai hard fork, stETH and bETH should converge to the price of 1 ETH, as users will be able to arbitrage between ETH and their liquid staking derivatives.

In contrast, rETH is designed as an appreciating token. Therefore, the rETH-ETH exchange rate will increase over time. However, trading rETH back to ETH depends on protocol liquidity, which is limited before withdrawals are enabled. Consequently, the market price of rETH has fluctuated over the past year.

Price Performance of Liquid Staking Derivatives

Source: CoinGecko

Before May of this year, due to high demand for staked ETH, the trading of stETH was essentially flat with ETH. This further reinforced the (incorrect) notion that stETH was "pegged" to ETH, similar to how 1 USDC is pegged to 1 USD, giving market participants confidence to leverage their yields. In this trading, participants deposited their stETH into money market protocols (most commonly Aave) as collateral to borrow ETH, which they then staked to earn stETH and cycled the trade again.

Several Products Offering Leveraged ETH Staking Have Emerged

Market turmoil events starting in May forced large market participants, especially Celsius and Three Arrows Capital, to sell their stETH collateral. The lack of liquidity in stETH-ETH and crowded leveraged trading led many to attempt to exit through a narrow door.

Crowded Trading Through the Same Door

Source: Dune (@LidoAnalytical)

Market Pricing

bETH is currently trading at a 2.2% discount to ETH, while its "flexible" staking yield is 2.4%.

Developers have indicated that the Shanghai hard fork will occur within 6-12 months after the merge. Assuming these estimates are at the midpoint, this means the merge will occur around September 30, 2022.

Considering liquidity factors and market technical factors, this approximate method is not perfect but can be used to gauge market sentiment. The same operation can be applied to stETH, but we use bETH and Binance's flexible yield to exclude the impact of counterparty risk and more easily offset the opportunity cost of capital.

ETH/BTC

The ETH/BTC ratio is also frequently used as a sentiment indicator for Ethereum, while filtering out broader macro fluctuations that may affect overall cryptocurrency prices. Since May, major cryptocurrency events—such as Terra and Three Arrows Capital—have worsened the situation, as both assets were reportedly liquidated during this period. However, since early July, ETH/BTC has risen by 20-30%, stimulating further merge narratives.

Source: Binance, TradingView

Beneficiaries of the Merge

The price performance of some publicly traded tokens benchmarked against ETH also provides another interpretation of market sentiment.

Beneficiaries of the Merge Include:

Since June, most tokens in the above categories have outperformed ETH, with only a few exceptions.

Price Performance of Selected Tokens (Benchmarking Against ETH)

Polymarket

Polymarket has the largest merge prediction market. Although its liquidity is incredibly low, undermining its predictive ability, it provides another simpler way to gauge market sentiment regarding the merge.

Currently, Polymarket participants believe there is a 66% probability that the merge will occur according to the proposed timeline, with a 95% probability that it will happen by the end of this year.

Risks of the Merge

Execution risk. Good communication among all stakeholders is key to a successful merge. Before the merge, validators on the consensus layer need to perform multiple operations, such as updating the correct TTD value and keeping nodes updated and synchronized. User errors or misinformation could lead to node loss. The consensus layer clients may also have undiscovered bugs. If enough nodes fail, Ethereum could temporarily halt. There are also execution risks for applications or exchanges running on Ethereum.

The Ethereum community has been actively working to mitigate these risks. For example, the community has come together to improve client diversity, reducing Prysm's validator share from 68% in April to 41% today. This significantly reduces the consequences of potential bugs.

Miner risk. As mentioned in the previous section, miners' incentives will change before and after the merge.

Validator risk. A new set of network risks will emerge after the merge. One attack is the potential for denial-of-service (DoS) attacks. Proposers will be known in advance, incentivizing some participants to maliciously DoS validators. This also centralizes the process, favoring institutional validator pools that handle and mitigate DoS risks.

Complexity risk. Ethereum will effectively merge two independent networks, increasing technical complexity. To join the beacon chain, individuals need 2 clients. To run a validator, 3 are needed. To obtain MEV rewards, 4 are required. The risk is that as Ethereum modularizes and specializes, this trend will continue to the point where it becomes difficult for anyone to grasp the whole picture.

Vitalik also addressed this issue in a recent EthCC speech, calling on the community to start thinking about reducing Ethereum's complexity.

Vitalik's Ideal Long-Term Goal (Regarding Complexity, Not Price)

Conclusion