How The Merge Will Impact DeFi and Dapps on Ethereum

The Ethereum network is on the cusp of receiving its most significant upgrade to date, thanks to The Merge. It is a monumental occasion for the leading developer-oriented blockchain ecosystem, and it will shake up the DeFi and Dapp ecosystem in many ways.

The Merge Is a Big Deal

Ethereum supporters worldwide have been looking forward to The Merge, which is slated to activate on the Mainnet halfway through September 2022. It signifies the network's transition to proof-of-stake - although that will not yield faster nor cheaper transactions - and paves the way for future network upgrades such as sharding. However, many wonder whether the proof-of-stake transition will unlock additional capital. More specifically, capital that has an ESG mandate.

It is no secret there are serious concerns over the electricity consumption of proof-of-work blockchains. Bitcoin and Ethereum have received a lot of criticism over their electricity consumption and environmental impact. Following The Merge, Ethereum's consumption will decrease significantly, as staking does not require expensive and power-hungry mining hardware.

As the Ethereum network becomes "greener", there may be an influx of fresh capital. That may not necessarily result in a higher Ether price on the market but rather materialize through funding new or established projects. Less environmental impact can be a strong selling point to attract VC funding and boost company valuations. However, one cannot overstate the importance of The Merge either.

More specifically, the impact of The Merge on decentralized finance and Dapps built on Ethereum will be minimal. It is not an upgrade that makes the next more efficient, cheaper, or provides more capacity. Everything will continue to operate as normal, and developers can continue their work unabated. However, there may be changes to the network's tokenomics, especially where block rewards are concerned.

A Shift in Rewards and Their Perception

Ethereum supporters have been able to stake Ether prior to The Merge activating on the network. That has resulted in roughly 13.3 million ETH - or 11% of the circulating supply - entering the staking contract. While users have not received any rewards for doing so - those will unlock in the next upgrade dubbed Shanghai - it confirms growing interest in proof-of-stake.

Moreover, liquid staking - through Lido and other providers - allows supporters to accumulate more ETH ahead of this transition while retaining their network liquidity.

However, the real liquidity to watch is the block rewards, and how they will impact the Ethereum tokenomics. Radix Protocol Head of Partnerships Ben Fargher explains:

"The ETH emissions (or block reward) used to pay "miners" under Ethereum's Proof of Work system will instead be used to pay users who stake ETH to secure the network, and the "validator" node-runners who will now validate Ethereum transactions under the new regime. This will affect the rate of supply of new ETH and give ETH an effective monetary base rate of in the region of ~4% per annum. This is not true yield as some commentators have put it, as it is paid out of an inflating total supply of ETH, not from some exogenous source as you might expect, say out of a bond coupon. Those that don't stake, by being diluted, are effectively paying those that do."

That illustrates the shifting mindset all Ethereum supporters will need to face eventually. Not everyone is required to support the network through staking, but not doing so will result in a value transfer to those who engage in this activity.

It may not necessarily be a visible shift - as in, wallet balances will not move around - but one cannot deny the importance of engaging in proof-of-stake.

That said, the "rewards" for stakers and validators will usher in a new era of monetary policy for the Ethereum network. As a network with an uncapped supply, the emission rate and rewards do not make ETH more scarce. Not much will change on that front compared to how miners earn rewards today, even if the algorithm to distribute that value is different.

Don't Overlook Potentially Crucial Changes

Even though the proof-of-stake transition and rewards get the most attention, there is more to The Merge. Like any other major network upgrade, a lot of "smaller" things will change. Some of these upgrades may seem insignificant at first, yet Bitcoin.com DeFi Tech Lead Vitalik Marincenko highlights one crucial development that can impact all Dapps on the Ethereum blockchain.

"On the technical front, something that hasn't received a lot of attention is the ability to generate random numbers on-chain, which will be implemented with the Merge. Random numbers are critical for a huge range of applications, so with randomness delivered on-chain, it will mean reduced costs for DApps (who have so far been reliant on ChainLink oracles with their associated costs)."

Cost reduction to operating on the Ethereum network has always been a pressing topic. It can be expensive for DApps to perform transactions depending on overall gas fees and using external data sources. Therefore, the introduction of random numbers on-chain can make a huge difference for DApp developers and users alike. While it will not make ChainLink oracles obsolete overnight, it will provide developers with an extra option. Having extra options is priceless in any work environment.

DappRadar Head of Research Pedro Herrera echoes a similar sentiment:

"As Ethereum becomes more efficient, the Dapp ecosystem in this network can burgeon even further. As Ethereum upgrades, scaling solutions like Polygon, Optimism, and Arbitrum should also benefit from this transition. While the Merge does not enhance Ethereum's scaling capability or gas fee structure, it plays an essential role in achieving sharding in the Layer 1 chain. For DeFi itself, it is too early to tell and a bit speculative, but different scenarios can unfold."

Although The Merge should not cause any network interruption, that remains one of the potential network scenarios. In addition, all AMMs will need to adjust their algorithms to accommodate the new market conditions. That will likely spill over to collateralization requirements for minting stablecoins like DAI. A big change is coming courtesy of The Merge, and it is crucial everything goes off without a hitch.”

A Crucial Time for Ethereum

The Merge marks a significant development for the Ethereum network. The core developers decided to split this update into two parts - Bellatrix , on September 6, and Paris, between September 10-20. That announcement came shortly after the discovery of Merge burgs in two of the Ethereum clients - Geth and Nethermind - although those have been resolved by their respective developers.

Traders and investors took a break from exploring Ethereum derivatives last week, resulting in a steep ETH price decline. Interestingly, money poured back into these derivatives this week, propping up the ETH price. There is substantial activity for trading ETH ahead of The Merge, which may yield even more volatility in the coming weeks.