Ethereum 2.0: Why the paradigm shift is so important for Ether

4 months ago

Ethereum 2.0: Why the paradigm shift is so important for Ether

Ethereum is the most successful cryptocurrency in the world after Bitcoin. This is primarily because Ethereum did not try to be a competitor to Bitcoin and have a currency function or one as a store of value, but opened up a completely new dimension for blockchain technology. The biggest achievement, which most of our readers have probably also come into contact with, is the smart contract.

This niche is no longer unique today and many cryptocurrencies are competing with Ethereum. Over the last 4 years, projects kept stepping up to be a better alternative to Ethereum as a smart contract platform. Among them NEO, Cardano, Algorand, Solana and Polkadot. So far, no one has managed to replace the elegant system that Ethereum has created. The market still relies on the Ethereum blockchain and many projects are therefore dedicated to how to be interoperable with Ethereum rather than how to replace it completely.

Nevertheless, Ethereum needs and wants to change, and recent events underscore why this is so sorely needed. In today's article, we're going to address the question of what Ethereum 2.0 is all about and why this change is needed in the first place.

Fees on the Ethereum blockchain are exploding

Last year, the DeFi hype took off and hundreds, if not thousands, of new applications were created on the Ethereum blockchain. Along with the great utility that many of these applications bring, the demand for interaction on the blockchain also increased. In this process, every transaction and interaction with a smart contract requires Ether to pay for the fees incurred.

The more participants want to use this system, the more fees they have to pay. They are competing with each other to see who gets to initiate a transaction in the shortest amount of time. With this demand, the fees have also increased, which is very pleasing for the miners, but a disaster for many users.

If you try to handle smaller sums, the fees can exceed the value of the transaction, depending on the workload of the network.

Proof of Work vs Proof of Stake

The Ethereum blockchain to date has relied on Proof of Work. The model was the most secure system known at the time Ethereum was developed. Bitcoin also relies on Proof of Work and is therefore considered very secure. The advantage is decentralization and security, but that comes at the expense of speed and transaction output.

So Ethereum, with its smart contracts to tokenize assets or decentralize insurance and trading, is trying to serve use cases that simply require better or higher scalability. This cannot be achieved with the current blockchain and thus it was clear that a new solution had to be created.

In the meantime, many experts agree that Proof of Stake is at least as secure as Proof of Work and the developers of Ethereum 2.0 have also come to this conclusion. With this, they not only want to make the Ethereum blockchain more environmentally friendly, but also increase the transactions per second.

Sharding: Ethereum splits into many chains

Ethereum 2.0 relies not only on one blockchain, but on a multitude of Chains that can interact with each other. The idea behind this is relatively simple. Each of the individual blockchains can serve very specific use cases, and in order to finalize transactions, it communicates regularly with the mainchain.

This better distributes the overall workload, while the trust-building protection of the Ethereum blockchain is the final authority to record transactions and agreements. Currently, 64 different blockchains are planned for the beginning, which will gradually interact with each other and go through various testing phases beforehand.

Since the Ethereum 2.0 blockchain is a completely independent one, it will run separately until itis merged with the old blockchain. However, the old chain will not automatically become obsolete, but is to be linked to the new one as one of many chains and merged. In this way, all aspects that cannot be ported, if necessary, can remain at home on the old chain.

What happens to the existing Ether?

As is readily apparent from the previous explanations, the old and new Ethereum blockchains run separately, which presents new technical challenges. The Ethereum 2.0 blockchain officially started on Dec. 01, 2020, by depositing at least 540,000 Ether into a smart contract on the old blockchain.

Thus, anyone who has deposited ETH into the smart contract of the so-called Beacon Chain and has become a validator automatically holds the same amount of ETH2. While the two blockchains run in parallel, no transactions can take place between them. Anyone holding ETH2 will have to be patient until the old blockchain can be linked, after which they will be able to interact with the old ecosystem or own "full-fledged" ETH again.

In the end the cryptocurrency Ether will be merged and it will not matter to most end users and investors in this regard which blockchain they are currently on. After the merge, all investors will keep their coins as is, but will then all be able to switch to the new blockchain, if that hasn't been done before.

Staking with Ethereum 2.0

The changeover of the consensus mechanism enables investors to participate in staking as well. Primarily, Ethereum has so-called validators. 32 ETH must be deposited per validator in order to be qualified as such. This is a variation of Proof of Stake, because other cryptocurrencies still know the concept of delegating coins. Examples of this are Tezos or Tron.

In the case of Ethereum 2.0, it is intended that they validators provide the said deposit and also operate a corresponding network node, which must have a certain temporal availability per day in order to also be allowed to perform its tasks. Because 32 ETH is not affordable for every investor and the operation of the validator also requires appropriate expertise, one can alternatively use a pool for staking. These pool the deposits of small investors and form and operate validators with them.

The reward, which is achieved by the validators, is shared by all participants similar to a mining pool. The pool itself generates a fee. Thus, ETH2 also enables small investors to generate passive income, although mining will be abolished in the long run.

Interoperability is becoming increasingly important

Ethereum 2.0 illustrates a step that can also be observed in other blockchain projects. It is becoming increasingly important that different blockchains can interact with each other. On the one hand, different ecosystems can be linked, and on the other hand, resources can be used in a more targeted manner.

Ethereum wants to use this idea to differentiate between different Chains in its own ecosystem and make use of their capacities. It is becoming increasingly clear that this will also include blockchains that have been designed as independent systems. Examples include Polkadot and, most recently, Cardano, which aims to create smart contracts via Glow that will ultimately also be compatible with Ethereum.

Interoperability and the ability to provide it in any direction needed is thus becoming increasingly important, and Ethereum is definitely experiencing competition in this regard.

The roadmap -when will everything be ready?

Due to the time factor and competition Ethereum is experiencing right now, many investors are eager to see how ETH will perform. On the one hand, the fees are painful for many investors and users, and on the other hand, the length of time for the full release of Ethereum 2.0 is definitely an important criterion when evaluating the investment.

The roadmap is long and in some respect it is not clear when the specific steps can be processed or achieved. All in all, it could take between two to three years until all goals have been implemented. But of course, that doesn't mean significant progress can't be made in the meantime.

By the end of the year, the first shards -as the sidechains are titled -could already be completed and interacting with the actual blockchain. However, in order for this to happen, the actual Ethereum blockchain must be put through its paces, and the shards also need a long testing phase before they can actually be productive. This means that many features will not be available for the foreseeable future.

For example, Ethereum 2.0 does not currently have smart contracts and will have to unlock these and other functions step by step. After the launch, people were namely concerned with the pure basics of the new blockchain, namely the question of whether Proof of Stake works smoothly.

Will ETH become scarce as a result?

The question cannot be answered in the affirmative in all respects. The total amount in circulation will not be further increased or made scarcer by the process or conversion. However, ETH2 cannot be used in the market until the merging of the chains has been completed.

This actually gives a temporary limited shortage because ETH2 is de facto not available in the market and cannot be traded. Some of the staking pools get around the problem by issuing a wrapper in return. For example, the staking protocol Lido pays out 1 stETH for each ETH deposited. With stETH, stakers have the ability to convert their stETH back to ETH at any point in time or use it in other DeFi applications.

The key point is that even when a wrapper is received, the ETH once deposited cannot be transferred back to the old chain again. Therefore, it is no longer available to the market. Whether this scarcity has a bullish effect on the market is questionable.

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