Ethereum 2.0: Impact on Users, DApps, DeFi and Markets

Ethereum (ETH), the second-largest cryptocurrency by market capitalization, is expected to launch its much-anticipated ETH 2.0 upgrade in the second half of 2020. The upgrade marks a major shift for the blockchain network as it switches its consensus mechanism from Proof-of-Work (PoW) to Proof-of-Stake (PoS) in a bid to improve scalability and introduce new features.

Also known as Serenity, the ETH 2.0 upgrade was first announced during Ethereum co-founder Vitalik Buterin’s 2018 Devcon speech. According to the original plan, there are 4 phases of the upgrade (phase 0-3). While Phase 0 was scheduled for 2019 and Phase 3 was expected to be completed by 2022, the launch has been delayed multiple times due to changes in the governance structure of the core development team. 

However, with Buterin recently pointing towards Q3 2020 as a possible time frame for launch, OKX Insights examines the significance of the transition to PoS and new features, like staking, and the upgrade’s impact on existing ecosystems such as Decentralized Finance (DeFi) and Decentralized Applications (DApps).

PoW vs PoS — energy savings at stake

Ethereum’s decision to change its consensus mechanism has reignited the debate between PoW and PoS proponents. PoW is the original consensus mechanism for blockchain, outlined by Satoshi Nakamoto in the Bitcoin whitepaper. It requires so-called “miners” to verify transactions and create new blocks using computing power. 

However, as competition increases and the difficulty of mining new bitcoins rises, the computing power requirements also go up, resulting in high energy consumption and environmental concerns. According to the Bitcoin Energy Consumption Index, the estimated annual Bitcoin energy consumption is 58.6 TWh per year. If Bitcoin was a country, it would rank 48 in energy consumption, trumping countries like Bangladesh and Romania.

Concerns surrounding Bitcoin’s energy consumption, over the years, have led to the emergence of alternative consensus mechanisms, one of which is PoS. This protocol removes the need for computing power (saves energy) and replaces miners with “validators” who verify transactions and create new blocks.

In comments to OKX Insights, Jehan Chu, the founder of the Ethereum Hong Kong community and the co-founder of Kenetic Capital, cited energy savings as one of the advantages of the upcoming upgrade for Ethereum:

“With the upgrade to Proof of Stake, ethereum holders will be able to more directly participate in and benefit from maintaining the network by staking (a minimum of 32 eth) rather than running complicated hardware and burning electricity.”

Chu added that he does not believe that Bitcoin would be able to make such a switch, despite the potential environmental benefits:

“While Ethereum’s move to POS is a strong signal for the industry, it is unlikely that Bitcoin will ever move to POS due to its sheer size, value, and governance model. This makes Bitcoin’s success bittersweet as the environmental impact will only worsen as Bitcoin gains value.”

While its positive environmental impact is likely to be a welcome improvement, Ethereum’s PoS upgrade will be accompanied by several changes and new questions for users and developers in the ecosystem.

ETH 1.0 to 2.0 migration: What will happen to your ETH?

For those who are wondering, the migration from the current Ethereum blockchain to the ETH 2.0 chain involves two stages: the transfer of users’ ETH and the status transition of the Ethereum blockchain.

The migration commences at the first stage of the ETH 2.0 upgrade, which is termed Phase 0, and begins with the launch of Beacon Chain — the new PoS blockchain for Ethereum.

Ether migration is planned via a “one-way bridge” mechanism, where users will be able to lock their ethers on the current Ethereum blockchain into a contract and get the same amount of ethers on the Beacon Chain.

Users can then stake the credited ether (if they have more than 32 ethers) and begin to earn rewards on the ETH 2.0 chain. The transfer transaction to ETH 2.0 is one-way, as the user’s ethers on the original Ethereum blockchain are then are burned.

While this is a simple and secure mechanism to transfer ETH to the new chain, the non-reversible nature of the transaction adds “lock up risk.” This risk refers to the fact that users staking their ETH on the new PoS blockchain “lock up” that ETH (meaning it cannot be sold) for a specific period, risking that the price of ETH could drop and they would be unable to sell it.

While ETH 2.0 lead developer Danny Ryan shared that there is community interest in creating a two-way bridge, he believes such a proposal can be assessed at a later date. Ryan also pointed out that, for users or holders of ETH, developers are trying to make the transition to a new blockchain “as seamless as possible.”

State transition — migrating ETH 1.0 data to 2.0

State transition refers to moving the existing blockchain data over to the new architecture. Initially, it was planned that the current ETH 1.0 chain would be transferred to a “shard” (a portion of the network) on the ETH 2.0 chain. However, there were various challenges to such a transition, which are now being addressed in a new proposal by Buterin.

According to Ryan, Buterin’s new proposal is being backed by core developers and is likely to be implemented soon.

Migration issues aside, the ETH 2.0 upgrade primarily delivers support for staking and scalability, which can impact some of the existing ecosystems that rely on the network, such as decentralized finance and applications.

Staking support for ETH holders

Staking replaces mining in PoS networks and validators who lock up their coins earn staking rewards for maintaining the blockchain ledger. These rewards are similar to interest earned on money deposits, making staking one of the passive income opportunities available in the crypto space.

The Ethereum 2.0 Staking Ecosystem Report by ConsenSys indicates that participants can stake their ETH by running their own validator nodes or using a third party staking provider. The report also summarizes its survey findings from 287 respondents, 32.8 percent of whom plan to run their own validator nodes and 33.1 percent plan to use a third party staking provider.

According to the report, participants intending to stake their ETH and run validator nodes are incentivized with an average expected return of 5.8 percent, whereas those intending to stake via a third-party provider can expect a higher average reward of 7.6 percent.

The current number of Ethereum addresses that hold at least 32 ETH (the minimum required by the network to be a validator and earn rewards) can give us insight into the number of potential ETH 2.0 validators. As of May 5, 2020, Glassnode data reveals that there are 114,550 Ethereum addresses with 32 ETH or more.

Ultimately, Ethereum’s support for staking is expected to attract wider network participation compared to mining on the older version. Charles d’Haussy at ConsenSys shed light on these incentives in his comments to OKX Insights:

“For people who hold ETH, Proof of Stake marks a more inclusive way to maintain the security of the ETH 2.0 network, along with comparatively high rewards for contributing to the security costs…platforms like exchanges, funds, and wallets offering staking will be a great way to contribute and benefit from ETH 2.0.” 

In comments to OKX Insights, Chu from Kenetic Capital highlighted the accessibility of third-party solutions that can make staking “as easy as signing up for an email address”:

“A high technical bar prevented many users from participating in the network but companies supporting ETH 2.0 with turnkey solutions like Alchemy or Blockdaemon (and eventually your favorite exchanges), make staking as quick and easy as signing up for an email address. This is critical in securing the network with a massive, diverse and decentralized validator group to guarantee security and resilience for the next 100 years and more!”

DeFi solutions to become more competitive

Decentralized Finance has a prominent place in the Ethereum ecosystem, accounting for 60 percent of the total value of Ethereum DApps as of May 2020. At the time of writing, over 2.5 million ETH (over $600 million) are locked in DeFi DApps, and the number can be expected to grow as users seek alternatives to traditional financial services.

However, scalability remains a stumbling block when decentralized finance applications are compared with their traditional counterparts, such as the Visa network, which can process thousands of transactions per second (tps). Currently, the Ethereum network is limited to less than 50 tps at best.

The ETH 2.0 upgrade allows developers to make scalability gains with technological implementations like sharding, which are expected to dramatically increase the number of transactions per second on the network. This could bring DeFi apps in line with traditional solutions.

DApps to benefit from scalability and new opportunities

Looking at the whole DApps ecosystem, data from Dapp.com shows that Ethereum is still the dominant platform in terms of daily trading volumes. Ethereum currently has a 71 percent market share, while its main rival EOS only accounts for 24 percent.

Jon Jordon, director of communications at DappRadar, believes that ETH 2.0 is an important milestone for developers in the DApp ecosystem. He told OKX Insights:

“In some regard, users shouldn’t really care about ETH 2.0. For example, they shouldn’t have to do anything different. The scalability that comes with Eth 2.0 will enable developers to create much more interesting and fluid DAppsapps [sic] however, which is something to be excited about.”

While Jordan believes all categories of DApps will be beneficiaries of the ETH 2.0 update, he added that the scalability should allow for new types of DApps:

“Any DApp that requires faster transactions will benefit; gaming is definitely high on the list. But what I think is the most exciting is the opportunity for new types of DApps we haven’t yet seen on Ethereum but we do see in the normal Web 2.0 world such as social DApps.”

Another major change in ETH 2.0 is the removal of the “gas” fee from the Ethereum network, which could further boost DApp usage. Gas is the cost to perform a transaction on the Ethereum network. As the network gained popularity, there have been instances where DApps usage dropped because of the rising gas fee. In particular, the growing usage of the Ethereum-based version of stablecoin Tether (USDT) has routinely led to congestion on the Ethereum network.

In examining the impact of gas fees on gaming DApps on Ethereum, Jordon at DappRadar told OKX Insights:

“Higher gas prices generally reduce user activity because it costs more to get a transaction validated. However, this impacts different categories of DApps differently. For users moving around large amounts of value – say +$1,000 – in DeFi or exchange dapps, the fact the gas price has increased by a couple of dollars isn’t a big factor.

For games and other dapps where transaction value is much smaller, the gas price might be higher. It makes no sense to spend $5 on a $2 transaction so usage drops. In ETH 2.0 there is no gas fee as it uses a proof of stake consensus.”

Markets are preparing for ETH 2.0

With ETH 2.0 expected soon, market interest in Ether Options is notable growing. Options are a type of derivative product that give holders the right, but not the obligation, to buy or sell an asset (in this case ETH) at a given price before a given date in the future. 

According to Skew, the Open Interest of ETH options recently reached a new all-time high of $151 million, reflecting the inflow of fresh capital.

Deribit and OKX are the main cryptocurrency exchanges that offer ETH options trading and the surging open interest is potentially a bullish signal for Ethereum.