The Ethereum network is planning to fully transition from Proof of Work to Proof of Stake, via “The Merge”; The implementation of Shard Chains will come afterwards (earliest ~2023). As of Q2 2022, in addition to the Ethereum Mainnet, there is a Proof of Stake Ethereum network called the Beacon Chain, which went live in December of 2020 and in so doing introduced Proof of Stake to the Ethereum network. Those who stake ETH on the Beacon Chain will be granted validator privileges, meaning they will have a say in committing blocks to the chain. If a validator misbehaves, by proposing or attesting to invalid blocks, an algorithmic fine is levied (this is also called slashing). The fact of having funds at stake (at risk) incentivizes honest and scrupulous participation. Validators are incentivized to stake by standing to earn block rewards and transaction fee revenue.
When Ethereum fully transitions to Proof of Stake, “The Merge” will see the Ethereum Mainnet become a ‘shard’ of the Beacon Chain. The Merge will change the Ethereum network’s consensus mechanism (i.e. how nodes agree on the current and historic state) while the implementation of Shard Chains will offload data storage and access, thereby increasing the network’s transaction throughput and reducing network congestion. While Proof of Work is the only consensus mechanism to be proven, out in the wild, at scale by persistently prolific blockchain networks, the hope is that Proof of Stake will be just as secure. In order to launch a 51% attack on a Proof of Stake network, the attacker(s) must have at least 51% of the staked funds (tens of billions of dollars worth for the Beacon chain as it currently exists).
Proof of Stake is a consensus mechanism whereby validators essentially take over the function of miners; helping the distributed network agree on the ordering of transactions. Proof of Stake is preferable to Proof of Work insofar as it doesn’t require computationally expensive hashing (as Proof of Work does), meaning that less sophisticated hardware is required in order to participate in achieving network consensus and earning rewards. It is also hoped that Proof of Stake will lead to more nodes in the network (from thousands to hundreds of thousands), with associated security benefits and redundancy. Additionally, ETH will no longer require the same amount of energy as a small nation state to securely propagate the blockchain.
Another benefit of staking is that it lends itself rather well to supporting Shard Chains, since these various chains need coordinating; the Beacon Chain shall manage this coordination. After a successful merging of the Ethereum Mainnet and the Beacon Chain, 64 Shard Chains will be launched and run in parallel. Each of these Shard Chains will have the capacity of the pre-merge Ethereum mainnet, therefore Ethereum could see its transaction throughput (empirical capacity over time) increase by orders of magnitude. Transactions on Shard Chains will be included in Shard Blocks and voted on by a committee of at least 128 validators, so long as at least 2/3rds of the validators agree, the block is finalized (committed to the blockchain).
The Shanghai Upgrade is planned to occur after The Merge and will include the ability to withdraw ETH staked on the Beacon Chain. The Beacon Chain currently has over 11 million ETH staked (~9% of ETH’s supply), with a market value of approximately $34 billion, and approximately 350,000 validators. Staking ETH on the Beacon chain presents an ~4.5% APR interest earning opportunity for validators.
In order to run a validator node on Ethereum’s Proof of Stake network (the Beacon Chain) one must stake 32 ETH. This sort of solo (or home) staking is a boon to the decentralization of the network, since each validator is acting independently and is truly an ‘individual; meaning that any conspiracy between nodes to corrupt the network would involve at least as many individuals as there are solo node operators. Solo staking stands in contrast to Staking as a Service, Pooled Staking or staking via a centralized exchange.
Staking as a service involves outsourcing the technical complexity involved in the management of the validator client software (running a node) to a third-party; the user (or customer) is still required to stake 32 ETH and manage their validator keys. This method will not maximize returns for stakers since the service must be paid for, nor will it provide the same degree of decentralization as Solo staking.
Pooled Staking allows users to contribute to Proof of Stake with any amount of ETH, so is a viable option for those who don’t want to (or aren’t able to) commit ~$100,000 of capital to the Beacon Chain. Pooled Staking is also popular because of innovations around Liquid Staking. Since ETH staked to the Beacon chain is not currently redeemable, interim solutions have been developed whereby users are given an ERC-20 token that represents their staked ETH. The fate of these staked ETH tokens (such as stETH) after the merge, remains to be seen. Depending on the amount of time it takes to withdraw ETH staked on the Beacon chain (following the Shanghai upgrade), among other things, stETH will trade at some function of ETH’s price.
Centralized Exchanges also provide staking services, allowing users to earn rewards on their ETH. Since such exchanges typically manage user’s private keys on their behalf (meaning that a user losing their private key or seed-phrase doesn’t mean losing their crypto), staking via centralized exchanges is very user friendly. It introduces dangerous single points of failure and honeypots (motivation to find exploits), however, as exchanges consolidate large quantities of ETH and run many validators.
There is an awful lot at stake (pun intended) with Ethereum’s planned Merge. The possibility of some nodes refusing to update their clients and switch to Proof of Stake exists, which would mean another hard-forking of the network into two incompatible chains (a la Ethereum Classic), though the Difficulty Bomb is intended to mitigate this risk by rendering Proof of Work mining on the old chain no longer economically viable. There’s also a risk of some major bug or imperfection in the implementation causing havoc during the merge.
Assuming The Merge happens, we will see significantly more ETH staked than we do currently. Ethereum’s transition to Proof of Stake is also expected to include a reduction in the issuance of ETH as block rewards. The number of ETH issued, in an inflationary fashion, will be on a sliding scale depending on the amount of ETH staked across the network (where more ETH staked means more ETH issued); the potential staking returns for validators also decrease as more validators join the network, though more ETH is issued. When the burn mechanics introduced via EIP-1559 are taken into account, along with the above observations suggesting more ETH will be staked in the future, a clear argument can be made that we’ve already seen the peak of ETH’s circulating supply.