The New Realm of Ethereum 2.0.
By: Ross Carter-Brown
Tags: Blockchain, Defi, Ethereum, Fintech

Cryptocurrency

The New Realm of Ethereum 2.0.

Staking, Sharding, and Other Strange Stuff.

By Jack Moreh on Stockvault

The second-largest blockchain in the world, Ethereum, is preparing for a big shift in their model of operation. The switch to ETH 2.0 was planned right from the Ethereum launch five years ago, but it took a lot of time and the efforts of many development teams to reach this critical point when everything can start to unfold.

The entire crypto world is anticipating the Ethereum 2.0 beacon chain launch, confirmed for December 1st after 16,834 validators transferred the necessary 524,288 ETH into a deposit contract. This amount satisfies the threshold requirement for the upcoming ETH 2.0 launch. Only a few weeks ago some commentators expressed doubts whether the deposit contract would reach the necessary threshold by the deadline, November 24. Still, it is all over now, and the Ethereum developers are ready to activate the beacon chain of ETH 2.0.

There is a very positive atmosphere in the entire Ethereum community because this special moment marks the beginning of a complex network upgrade that has been delayed for a long time. In this article, I will dive into the Ethereum 2.0 subject. I will explain in detail why this gradual switch away from the current ETH 1.0 is so important, not only for the Ethereum ecosystem but for the entire crypto community as a whole.

What is ETH 2.0?

Ethereum 2.0 is the next chapter of the evolution of the Ethereum protocol. It will be a major milestone for the Ethereum community, five years after the invention and launch of the first cryptocurrency capable of running smart contracts (decentralised applications) on top of its blockchain. Currently, Ethereum is using a PoW (Proof of Work) consensus algorithm to validate the new transactions almost the same way as Bitcoin does. PoW algorithms require miners to run the blockchain nodes and a lot of computing power, meaning a lot of electric energy to keep the network secure and running.

Despite the tremendous efforts the developer teams put into improving the PoW algorithms, it is becoming more and more apparent that the inherent limitations of PoW blockchain technology won’t be solved unless we move to an entirely new concept of thinking. That is what the Ethereum developer’s community is doing right now with the ETH 2.0 upgrade — moving away from the old PoW paradigm and switching to the new PoS (Proof of Stake) consensus mechanism.

Proof of Stake (PoS) vs Proof of Work (PoW) Consensus Algorithm

The most crucial difference between ETH 1.0 and ETH 2.0 is that the new PoS algorithms will rely on a proof of Ethereum ownership and move away from the costly PoW mechanism, where extremely complex and power-intensive computations have to be done in order to keep the network operating securely.

Each Ethereum 2.0 transaction will be validated through the so-called staking process. After the Ethereum 2.0 transition is fully implemented, the Ethereum network will become much more environmentally-friendly than many other blockchains, still relying on different PoW consensus algorithms, including Bitcoin. Currently, there are no plans for any algorithm changes of the Bitcoin PoW mechanism in the foreseeable future.

With a PoS algorithm, the Ethereum network will use a pseudo-random process to select a node to be the next block validator. Why is the process called pseudo-random? The reason behind this name is the combination of randomness, and few other factors like how long the coins are staked (node age), or how many coins are staked with this particular node (node’s wealth), combined with the reliability of the node, like uptime. In PoS systems the blocks are “forged” instead of “mined”.

The Scalability Issue Solved

One of the most considerable improvements that will happen with the transition to ETH 2.0 will be the final solution to the scalability issue. As it currently stands, only 15 transactions can be processed on the Ethereum network per second. This often leads to congestion, slow transaction speed and even failed transactions when the gas fee is not sufficient. This issue should be entirely solved, allowing the final throughput to be in the tens of thousands of transactions per second. How will this be achieved? The solution is simple and elegant, the so-called sharding mechanism, already implemented experimentally in a few other blockchains like Zilliqa, for example.

Think of a light bulb. What happens when it breaks? It breaks into thousands of shards. Almost the same way as the Ethereum network will be able to break into shards. Different protocols and smart contracts can operate their own shards as well. These sidechains (shards) will function in parallel without congesting the mainnet. It will allow the Ethereum network to execute thousands of transactions per second without any interruptions. Ethereum, in its current state, is so slow because every single full node, operated by Ethereum miners, must validate all transactions before storing the new entire database of the Ethereum. This way of operation can only be scaled linearly; no matter how many nodes operate the network, there is a hard cap on the total number of transactions the system can output in a given time.

Ethereum 2.0 overall architecture. Original diagram by Hsiao-Wei Wang.

The network congestion is the main reason behind the other big problem of Ethereum at this moment: the increasing transaction fees on the network. Due to the exponential increase of the usage of the Ethereum network recently, the cost of a single transaction started to rise significantly making the small transactions not a viable options. The PoS consensus algorithm, combined with sharding technology, will fully solve the transaction cost issue. PoS will ensure that the validators reward will be proportional to their stake, and not to the number of transactions per second. As a result, it will open the possibility for practically unlimited scalability and much lower cost per transaction.

The Ethereum Network Transaction Fee Chart shows ETH paid as a transaction fee for the Ethereum network per day. Source: etherscan.io

There are several different opinions at the moment how exactly the sharding mechanism will be implemented correctly to solve the scalability issue fully. Some developers are in favour of the so-called Layer 2 scaling solutions, like ZK-rollups (for example Loopring). Layer 2 is essentially a framework that lies on top of the existing blockchain. This framework allows the users to do off-chain interactions that typically happen on the blockchain itself, thus increasing overall speed and scalability.

Rollups are essentially programs that bundle multiple separate transfers into a single blockchain transaction, thus reducing the network congestion and increasing the output up to 1000 times. Shards may become the next level of advancement in ZK-rollup architecture. The major difference between rollup and shards, however, is that the first one is an off-chain application that aggregates transactions in an Ethereum smart contract. In contrast, shards are separate branches of the blockchain, which operate within their own transaction speed limits but are interconnected and talk to each other.

Security Improvement over ETH 1.0

The implementation of consensus mechanism using multiple interoperable sidechains will significantly reduce the chances of 51% attack on the network as it will not be one network anymore. Even if somebody hypothetically attacks one of the sidechains, there will be many others to counter the attack and keep the whole network operating securely. With PoW consensus, it is possible (at least in theory) that few big miners can maliciously cooperate to break the network security like double spending coins.

In the case of PoS network in every attempt for a fraudulent transaction, the forging node will lose part of its stake and the right to participate in the future validation and staking. So as long as the stake is higher than the reward, the validator would lose more coins than it would gain if trying to cheat. With PoS, where the distribution of power is evenly distributed between node operators and where the actual wealth of the stakeholders is at risk, network attack will be practically impossible. This is a significant advantage over the traditional PoW consensus algorithms. It is well known that many smaller PoW networks suffered from a 51% attack.

ETH 2.0 Phases Explained and Expected Timeline

Phase 0 — The Beacon Chain

The critical mission of the Phase 0 (the beacon chain) is to establish and maintain the new PoS consensus algorithm and run it on a new blockchain that will operate as the central coordination hub for ETH 2.0.

Phase 1 — Sharding Technology

During Phase 1, the shard chains (parallel blockchains) will be created and connected to the already operating beacon chain, allowing a significant increase in transaction output and improved scalability. The two-way communication between all the shard chains will be the most significant technical challenge.

Phase 1.5 — Merging Mainnet with ETH 2.0 Beacon Chain

This intermediate step will set the moment when the ETH 2.0 and the old ETH 1.0 will be merged and interconnected between each other. At this point, all Ethereum coins will be ETH 2.0 coins, and all the Dapps will migrate as well on top of the new blockchain.

Phase 2 — Fully Functional Shard Chain

In Phase 2, the sharding mechanism will be fully implemented with 64 shards operating in parallel. The plan for the old PoW blockchain is not a destruction, but quite the opposite, using it as an additional shard involved in securing the new Ethereum 2.0 network. New complex smart contract functionality will be available to the developers.

Timeline Infographic of the Main Ethereum 2.0 Phases and Expected Times of Completion

New opportunities ETH 2.0 gives from an investment standpoint of view

Proof of Stake will bring all Ethereum holders a unique revenue-generating capability. Validators will earn a staking reward with an APY (annualised return) somewhere between 5% and 21% paid every six minutes based on the amount of ETH they stake. The more people start staking, the lower the yield, but in all cases, it will not drop below 5% soon and can be as high as 21% at the beginning of the operation of the beacon chain. The APY will also be affected by downtime, like when the validator server isn’t running. Ethereum Foundation published a chart to show the expected amount of staking rewards a validator stands to receive.

“In brief, when the total amount of ETH 2.0 staked is low, the annual reward is high, but as the total stake rises, the reward received by each validator gradually decreases.”

To become a validator, you will need to have at least 32 ETH, currently worth over 18,000 USD. Validators will be responsible for storing data, processing transactions, and adding new blocks to the blockchain. You will keep the ethereum network secure for everyone, and you will earn new ETH in the process. To be able to operate as a validator, you will need a strong internet connection, powerful computer setup and some skills to set a node yourself.

Now, when you stake your ETH, it will become ETH 2.0. What does it mean? It means you will not be able to turn ETH 2.0 back into ETH 1.0. In other words, you can’t take back your ETH for about two years, up until the entire network starts running on ETH 2.0. The good news is that soon after the beacon chain launch, there will be many staking pools where you can deposit your Ether and stake with them. You will be able to harness the staking reward for your ether even if you have less than 32 ETH or you don’t want to run a validator node yourself. Some of these staking pools are large holders of both ETH 1.0 and 2.0, and they will allow withdrawals at any time. Still, you have to be careful in selecting the right pool, ensuring the pool integrity and trustworthiness, as we all know how many scams exist in the crypto space.

You can check and choose from a list of staking providers preparing to offer their services in the next month or two. At some point in time, the exchanges will start supporting ETH 1.0 and 2.0 conversion, which will significantly facilitate and speed up the adoption of the new Ethereum blockchain. Coinbase has shown interest in supporting ETH 2.0 staking rewards. Also, a well-known crypto lending and borrowing platform Celsius Network has shown interest in offering ETH 2.0 staking to its clients. There are staking pools like Rocket Pool and Stkr, which both are planning to tokenise the stacked Ether into ERC20 token, respectively rETH and aETH tokens. The tokenised ETH 2.0 will mostly solve the liquidity problem because these tokens, representing a real stake in the Ethereum 2.0 blockchain can easily be exchanged or stored in a cold wallet or even deposited in DeFi (Decentralised Finance) products.

Projected return on 100 ETH staked over ten years, source: EthereumPrice.org

As peculiar as it sounds, the success of the DeFi protocols may become the biggest obstacle for the widespread adoption of ETH 2.0. The Ethereum holders will chase the best possible yield, and if it turns out that DeFi can generate higher yields than the ETH 2.0, staking the new blockchain will have difficulties attracting the necessary funds, sufficient to secure the new network. The Ethereum community, however, is quite diverse, and many participants strongly believe in the new paradigm of staking.

What will be the impact of ETH 2.0 release for the long term Ethereum adoption?

If you want to assess the long term impact ETH 2.0 will have on the Ethereum ecosystem, you have to take into account all the benefits that the new blockchain provides. First of all, improved scalability will allow more players to enter the Dapps space. Keep in mind that the Ethereum network is responsible for maintaining not only the ETH coin but also the entire spectrum of tokens that rely on the same infrastructure, including all the DeFi applications. Thus, the upgraded Ethereum 2.0 network will offer a more secure and significantly more scalable and robust solution for all the developers and end-users.

The eventual success of Ethereum 2.0 will imminently translate into better adoption and potentially much higher prices of the ETH coin. This investment thesis relies on all the hard work already done by the developers to make the switch happen. We are still at least two years from the final ETH 2.0 chain, with sharding implemented, but the transition process is well on track to meet the current timeline without significant delays. If the development continues at the same pace, and there are no significant roadblocks, it is inevitable to see investors reassess the entire valuation of the new Ethereum blockchain.

The main challenges ahead are not in the actual technology of transition of Ethereum network to functional ETH 2.0 blockchain but in the successful transfer of all the currently active Dapps from ETH 1.0 on top of the new blockchains. The goal is to allow a smooth and controlled transfer. Still, when it comes to such a big technological leap, potential risks of incompatibility issues and business disruption can’t be entirely excluded. If the transfer of the entire Dapps ecosystem is successful, the new capabilities of the ETH 2.0 network will expand the horizon for better and more robust DeFi projects and many other applications not possible at the moment.

Comparing the ETH 2.0 Features with Other PoS Protocols in Development

The development of the Ethereum 2.0 network is not happening in isolation. Many other protocols are competing with Ethereum to implement PoS algorithms for their blockchains. They are using a wide variety of approaches to solving the scalability issue. More than 350 blockchains are using variations of PoS consensus. However, only a few of them are large-cap coins ($1B+) or notable names like Cardano (ADA), Tezos (XTZ), Polkadot (DOT), Zilliqa (ZIL), Stellar (XLM), Cosmos (ATOM), Dash (DASH) and Neo (NEO). Cardano, for example, is utilising a little bit different approach with its DPoS (Delegated Proof of Stake) consensus algorithm.

The Cardano approach to the scalability problem is quite different from the Ethereum sharding mechanism. Their Ouroborus Hydra protocol will allow using multiple layers on top of each other. Each staking pool can create a new Hydra’s head, which can help to scale linearly with the number of pools participating. Hydra will deliver very low transaction latency and minimal storage of blockchain data per each node. This model, however, is still on paper, and maybe we are still a few years away from seeing it in action.

On the other hand, Zilliqa blockchain is already using a kind of sharding algorithm which enables massive scalability of the platform. These networks are also known as “Ethereum killers”, because of their potential to replace Ethereum. Most of them have already proven a working PoS consensus algorithm and distribute staking rewards to their stakeholders.

The problem with all these networks is they have a smaller user base, meaning smaller adoption. Another significant obstacle these blockchains are facing is the lower popularity of their smart contract programming languages like, for example, Cardano’s Haskell or Tezos’ Michelson among the developers’ community. Quite the opposite, there are many thousands of developers who are already using Solidity, Ethereum’s programming language. The number of libraries and documentation supporting Solidity smart contract developers is already huge and well organised. According to Dapp.com’s Q2 2020 report, there are 1,394 active decentralised apps in total as of June 2020. Of those, 575 or 41%, run on Ethereum.

In this respect, Ethereum 2.0 has an advantage over all of its competitors or so-called “Ethereum killers” and may even benefit from the development in their ecosystems. In the next 2–3 years, there will be a serious competition in terms of smart contract development capacity, transaction speed, blockchain scalability and security as well as usability showcases. Still, it is unlikely the Ethereum leading role will be conquered. The bigger and stronger development community of the Ethereum network will help to maintain the leading role in the next generation blockchains. It is quite possible that at the end of the transition to ETH 2.0, the situation will be described as “Winner takes all”.

There are already many indications that the attempts of all other competitive blockchains are not to replace Ethereum, but to access the deep liquidity through interoperability bridges, thus helping Ethereum gain even more functionality and broader adoption. There are still many challenges to be resolved and a closer view on the progress of Ethereum 2.0, and all competitors will be necessary if you want to be one step ahead in this game.

What are the people saying about ETH 2.0?

According to Vitalic Buterin, Ethereum is moving toward what he is calling “a rollup-centric Ethereum”. According to him, “If everyone moves to rollups, we will soon have ~3000 TPS”. This may seem a giant leap from the current 15 TPS (transactions per second), but it is not the end goal. As Vitalic Buterin states, once Phase 1 is completed with shard chains operating, the theoretical maximum speed will be 100,000 TPS. He says, however, that from a practical point of view:

“It seems very plausible to me that when Phase 2 finally comes, essentially no one will care about it. Everyone will have already adapted to a rollup-centric world whether we like it or not”.

He is optimistic that the scalability problem will be solved much earlier before the interconnected shards are rolled in Phase 2. Vitalic Buterin expects significant speed improvement with ultra-low latency (hundreds of milliseconds) within rollups operating across multiple shards, without the need for the entire blockchain to operate this fast.

The crypto investment research firms are frenetically working around the clock to deliver in-depth analysis about the impact Ethereum 2.0 will have on the crypto-economy. The renowned crypto-intelligence company Messari just released an ETH 2.0 report, with in-depth analysis of the implications the new blockchain will have.

The general public also seems optimistic about the future of Ethereum 2.0. The beacon chain launch gives hope for timely implementation of the next critical phases in the transition process to fully functional PoS Ethereum blockchain. If successful, the beacon chain will pave the way to a final solution of the scalability problems the network faces at this present moment. Exchanges are slowly preparing to meet the demand for Ethereum 2.0 staking. Given the size of the current blockchain and the wide variety of investors in ETH, most probably the switch to the new PoS blockchain will take some time. 2021 will be a transition year where the new and the old blockchain will operate in parallel but separately, with more and more stakeholders flipping their coins to ETH 2.0.

Conclusion

To summarise this comprehensive review, I want to emphasise the importance of ETH 2.0 for the overall success of the entire crypto-space. Suppose the transition to ETH 2.0 goes smoothly and follows the expected timeline in the next two or three years. In that case, the Ethereum ecosystem will get much more power relative to the other competitive blockchains. It will boost its role as the central hub for innovation and new technologies.

The future of the crypto-world may include multiple complementary blockchain ecosystems, but with a dominant part of Ethereum 2.0, coordinating most of the economic activities and controlling a significant portion of the cryptocurrency liquidity. You can already see the process of locking Bitcoins on top of the Ethereum infrastructure, like the Wrapped Bitcoin (WBTC), which resides as an ERC-20 token and can be easily used as collateral in multiple DeFi projects.

With Ethereum 2.0, such processes will only accelerate and attract even more activity on top of the Ethereum blockchain. On the other hand, if the challenges associated with the ETH 2.0 are bigger and more challenging to solve than initially planned, we may see a more fragmented crypto-space with multiple blockchains leading in specific technological aspects.

In both cases, Ethereum 2.0 will entirely change the way we think about cryptocurrencies. It will be a significant driver for more innovation, better security and more intuitive interface and user-friendly experience when it comes to dealing with cryptocurrencies.

Ross Carter-Brown