Cryptocurrencies: What to expect from Ethereum 2.0

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on February 24, 2020 - March 01, 2020.
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Cryptocurrency investors still remember the exciting year of 2017, when the craze surrounding initial coin offerings (ICOs) peaked. Back then, the price of ether, the cryptocurrency of the Ethereum blockchain, skyrocketed to more than US$1,300 each from about US$8 in the span of eight months. The meteoric rise of ether was due to growing demand from investors and speculators, who were buying it to invest in various ICO projects.

As at February, the price of ether had fallen to about US$200 each and the market capitalisation of the Ethereum blockchain has dwindled significantly. Reasons for these include the dying down of the ICO hype and the fact that many of the projects did not pan out. However, industry players say the price of ether could have a meaningful increase going forward.

The key driver of this potential increase is Ethereum 2.0, a significant system-wide upgrade from the existing one. It is expected to be rolled out in stages, starting in June and be completed by 2022.

“The price of ether could rise. I do not know if it will hit an all-time high, but I would not be surprised if it happens as it is a major event. The cryptocurrency market is relatively small [compared with traditional financial markets] and is easier to manipulate when there is major market news. We have seen huge swings in prices time and time again,” says Andrew Vong, chief future officer at EquitiesTracker Holdings Bhd and instructor of the company’s cryptocurrency masterclass.

TM Lee, co-founder of CoinGecko, a website that provides consumers with fundamental analysis on the cryptocurrency market, says it is possible that the price could rally on the back of the rolling out of Ethereum 2.0. While it is hard to tell whether it will surpass the levels seen in 2017 when Ethereum 2.0 is implemented, the expected price increase should be more sustainable than in 2017, he adds.

“The ICO craze was an outlier and it caught a lot of people by surprise. The market back then was mostly irrational and many people did not understand the blockchain industry enough,” says Lee.

“By comparison, the launch of Ethereum 2.0 could cause ether’s price to rise. The price will increase partly because of the better infrastructure being built. Developers who are working on various decentralised applications can build highly scalable projects at a lower cost on the Ethereum blockchain, which would lead to ether being more widely adopted and utilised.”

Edgar Gasper, chief operating officer of licensed digital asset exchange operator Sinegy Technologies Sdn Bhd, does not rule out the possibility of a rally in ether prices. “Whether prices will rise to the level where the market capitalisation of Ethereum eclipses that of bitcoin, like before — that is a tough call. But it could happen,” he says.

 

Enabling higher number of transactions per second

What is it about Ethereum 2.0 that excites investors? A key focus of the software upgrade is the implementation of sharding, which will exponentially increase the number of transactions per second.

In Ethereum 1.0, which is the current software, the blockchain can perform an average of 15 transactions per second — a fraction of what traditional payment systems can do. For instance, VisaNet, the centralised electronic payment system of Visa Inc, can perform 24,000 transactions per second, according to its official website.

Cryptocurrency players say this scalability problem has plagued the decentralised network industry for years. A limited number of transactions per second means that cryptocurrency users have to wait longer to pay and receive digital money. They can opt to pay a higher transaction fee to speed up the process, but this will add to their cost.

With sharding, Ethereum 2.0 could, theoretically, process thousands of transactions per second. “It is a significant increase. It also shows that the decentralised network is catching up quickly with the centralised, traditional ones,” says EquitiesTracker’s Vong.

Currently, miners of a blockchain, such as the existing Ethereum blockchain, consume computational power and electricity to solve a mathematical problem. Miners who solve the problem first will be able to mine a new block of transactions and be rewarded with ether.

The new block and recently completed transactions will then be validated by all the nodes, which are computers and servers around the world that keep a copy of the Ethereum blockchain’s public ledger, before being added to the blockchain.

When sharding is implemented, the validation process on Ethereum 2.0 will be different, says Vong. “All the nodes of a particular blockchain will no longer validate transactions that are stored in a single blockchain. Instead, they will be assigned to validate transactions in different shards, which can be perceived as sub-chains, in parallel with each other. And there could be hundreds or a thousand shards. This means that instead of a single-lane highway, sharding will turn Ethereum 2.0 into a multi-lane highway.”

 

Migrating to proof-of-stake

A notable change under Ethereum 2.0 is that the role of the miner will be taken out of the equation altogether as there will no longer be a function to mine for new blocks of transactions, like on the existing Ethereum 1.0.

Vong says Ethereum 2.0 will adopt the proof-of-stake method, instead of the current proof-of-work approach. The new method provides a new way to incentivise industry players to keep records of blockchain transactions and maintain its integrity on the system’s back-end.

“Under proof-of-stake, there are no mathematical problems to be solved and blocks of transactions will no longer be mined through the consumption of enormous computational power and electricity. Instead, new blocks will be assigned without being mined to nodes, or validators [through different shards or sub-chains without being mined]. Validators will validate these blocks of transactions and be rewarded for performing their task correctly,” he says.

Those who are interested in participating in the validation process will need to stake a minimum of 32 ether (equivalent to about US$28,160 as at Feb 7) with the Ethereum 2.0 blockchain.

“In layman’s terms, it is as if you want to get a broker’s licence from the regulator and it requires you to have, for instance, RM100 million in paid-up capital. So, the staking of ethers is the licence for you to participate in validating blocks and transactions to earn rewards,” says Vong.

“If you do not do your job properly and wrongly validate a block, you will lose your ethers that are locked up in a smart contract. In theory, this should incentivise you to do the right thing.”

There are two main benefits of such an initiative. First, because there will no longer be mining activities, the new method will consume much less electrical power and is more environmentally friendly than the proof-of-work method currently adopted by Ethereum, bitcoin and many other blockchains, says Vong.

For instance, a new online tool launched by the University of Cambridge last June shows that the bitcoin blockchain uses as much energy as the whole of Switzerland, or 0.21% of the world’s electricity supply. Several other reports have pointed out that mining bitcoins is more energy consuming than gold mining and harms the environment.

The adoption of proof-of-stake will also lower the barrier to entry for the general public to participate in the Ethereum blockchain and earn rewards. Those who wish to earn rewards by validating the blockchain no longer need to invest a significant sum of money to set up a server, buy a graphics processing unit (GPU) or application-specific integrated circuit (ASIC) to mine new blocks, says CoinGecko’s Lee.

“Anyone who has 32 ether and a laptop can probably stake their coins and earn rewards by validating blocks. The more money they stake, the more computational power they are required to contribute. But the amount of electricity consumed will be significantly less than that of proof-of-work,” says Vong.

 

Better infrastructure and prospects

Due to the higher number of transactions per second and a lower barrier to entry, it is not hard to see that the Ethereum blockchain will receive more attention going forward as ether becomes more commonly utilised, says Vong. “[In layman’s terms,] it is like a significant upgrade to the iOS system. The faster transaction speed and lower transaction cost of Ethereum 2.0 will encourage more developers to build various decentralised applications on it.

“Meanwhile, a lower barrier to entry will allow more people to participate in the network to validate blocks and earn rewards. The network will become more robust. All these could potentially lead to higher adoption and price of ether.”

CoinGecko’s Lee concurs. He says Ethereum 2.0 will encourage more developers to launch various decentralised applications on the Ethereum blockchain, especially decentralised finance (DeFi) projects that allow people to lend and borrow money on a decentralised network using cryptocurrencies.

DeFi projects include SALT Lending which allows borrowers to use their cryptoassets as collateral to secure a cash or stablecoin loan. There is also Singapore-based REN, which is developing solutions that allow cryptocurrency holders to lend and borrow digital currencies.

“If DeFi projects become more popular and serve the global need for an alternative financial system, I expect a trickle-down effect to happen. More developers will flock to the Ethereum blockchain to build new applications,” says Lee.

Other emerging trends in the blockchain industry, including security token offerings (STOs), could benefit the price of ether if they continue to gain traction in the market. Many of these offerings utilise the smart contract feature of the Ethereum blockchain to perform automated transactions.

“If STOs and other trends, including DeFi, become more popular, and if Ethereum remains the main platform for developers to build decentralised applications, [the price of ether could rally like it did in 2017],” says Sinegy’s Gasper.

There have been some concerns in the market that the Ethereum blockchain has been losing out to its rivals in recent years. But Lee says it has not faced stiff competition so far.

“We saw many [potential] ‘Ethereum killers’ launching in 2018 and 2019, namely EOS, TRO and NEO. These are all smart contract platforms with higher scalability aimed at competing with Ethereum. Based on what we can see today, none of these have come close to replacing Ethereum.

“Most developers looking to build decentralised applications still typically consider Ethereum first before using the others. The narratives of non-fungible tokens and DeFi have all taken off on the Ethereum platform.”

However, some notable contenders have been launched this year, he adds. “These rivals, such as Polkadot and Cosmos, aim to address the multi-chain interconnectivity issue [that Ethereum is facing]. There is also Libra which, if launched, can tap into the huge user base of Facebook and its ecosystem partners.”

 

Ethereum 2.0 road map

Ethereum 2.0 will be rolled out in three phases — Phase 0, 1 and 2. Phase 0 is expected to be kick-started with the launch of the Beacon Chain in July. The Beacon Chain can be thought of as the foundational level of the entire Ethereum 2.0 software. Its primary function is to cross-link information scattered between shards (sub-chains) and maintain the integrity of the whole blockchain, says CoinGecko co-founder TM Lee.

“When the Beacon Chain is launched, cryptocurrency holders can stake a minimum of 32 ether to it to mark a trial of commitment towards Ethereum 2.0.”

Phase 1 of the software upgrade is slated to take place in 2021, when multiple shards are deployed. Phase 2 is expected to take place in 2022, when Ethereum 2.0 will start to fully function.

“The implementation of the road map could be delayed. It has happened several times before,” says Lee.

In providing more technical details, he explains that Ethereum 2.0 is a separate blockchain from the existing one (Ethereum 1.0). However, Ethereum 1.0 is expected to eventually migrate to Ethereum 2.0. When that happens, there will be only one Ethereum blockchain.

Before the migration, those who stake 32 ether to become validators of Ethereum 2.0 will earn rewards in the form of a cryptocurrency known as “beacon ether” (BETH), says Lee. BETH can only be transacted on the Ethereum 2.0 blockchain when Phase 1 has been successfully deployed and cannot be withdrawn to the Ethereum 1.0 blockchain, he adds. “When the three phases of Ethereum 2.0 have been completely rolled out, BETH is expected to become ether.”

Thus, a key question on investors’ minds is: When will the migration happen? “There has not been any mention of it yet [as at Feb 11],” says Lee.

Edgar Gasper, chief operating officer of Sinegy Technologies Sdn Bhd (a licensed digital asset exchange operator), says the date has not been set yet. “The consensus is that it will happen eventually.”

 

Possible migration failure

While Ethereum 1.0 is expected to migrate to Ethereum 2.0, there is a risk of the two systems failing to merge, says Edgar Gasper, chief operating officer of Sinegy Technologies Sdn Bhd, a licensed digital asset exchange operator.

“If that happens, there will be two Ethereum blockchains and cryptocurrencies. This will not be good news for ether holders,” he adds.

However, the level of confidence in a successful migration remains quite high in the cryptocurrency and blockchain community at the moment, says Gasper.

CoinGecko co-founder TM Lee agrees. “Yes, a failure in migration will result in two blockchains and two cryptocurrencies, which will be ether and Beacon ether (BETH),” he says.

An industry player, who wishes to remain anonymous, says cryptocurrency exchanges could launch various instruments such as IOU or futures contracts for speculators to bet on the price of BETH before the migration happens. IOU, which means “I owe you”, is an informal document that acknowledges the debt one owes to another.

“Exchanges could issue IOU before BETH, which can be transacted freely. The IOU would allow people to trade and speculate on the price of BETH and its prospects. [When the shards are implemented,] these exchanges will then need to grant their promise to deliver the amount of BETH they owe to the IOU holders. These exchanges could also introduce [cash-settled] futures contracts, where no cryptocurrencies will be delivered,” he says.

The prices of ether and BETH will fluctuate based on their prospects, he adds. However, the price of both cryptocurrencies should be the same if the migration of Ethereum 1.0 to Ethereum 2.0 is deemed to a success by market players.

 

Current rally due to several factors

The price of ether has surged in the past few months. It has risen about 110% year to date to US$269 (as at Feb 18), according to CoinGecko.com, a website that provides consumers with fundamental analysis on the cryptocurrency market. The cryptocurrency recently hit a one-year high of US$284.

Industry observers say there could be a few reasons behind the price rally. An industry player, who wishes to remain anonymous, says it could have been due to the recent increase in the price of bitcoin.

A check on CoinGecko.com shows that the price of bitcoin has increased 34.72% to US$9,700 since the beginning of the year.“The price of ether tends to move when the price of bitcoin fluctuates, but with higher volatility,” he says.

Another factor that could have contributed to the recent rally in bitcoin prices is the upcoming halving of the cryptocurrency, slated for May, he adds. When that happens, the reward for mining a block of digital tokens will be halved to 6.25 bitcoins.

Some online news reports have pointed out that cryptocurrency market movers (big-time bitcoin holders, also known as “whales”) are also pushing prices up.

Has the news of Ethereum 2.0 been one of the factors in ether’s recent rally? Two industry players say it probably has not.

Matthew Tan, founder of Etherscan, an online platform that allows users to validate transactions that have taken place on the Ethereum Blockchain, says the implementation of Ethereum 2.0 would not have had much impact on the recent increase in ether prices.

CoinGecko co-founder TM Lee agrees. “I do not see any correlation between the recent increase in ether prices and news on Ethereum 2.0.”