How to Invest in Debt, Equity, and Commodities in One Investment

23 Takeaways ETH 2.0: The Next Evolution of the Cryptoeconomy

Wilson Withiam and Ryan Watkins assembled a comprehensive overview of the path from ETH 1.x to ETH 2.0 in their research report ETH 2.0: The Next Evolution of the Cryptoeconomy.

Outlining in detail the phases and development milestones required to make the transition successfully. My takeaways.

1. ETH 2.0 will transform ETH as an asset

ETH 2.0 is not just a major upgrade to the Ethereum blockchain; it is also a major upgrade to Ethereurm’s native asset ETH. ETH 2.0 will transform ETH as an asset, providing it with attributes of each of the three asset superclasses: capital assets, commodities, and stores of value-an unprecedented combination5. It will also fundamentally alter Ethereum’s monetary policy, which while perpetually inflationary for security purposes, will likely see inflation of less than 1% annually if not even lower…

Takeaway

If successful, ETH 2.0 implementation will create a zero to one asset combining the attributes of the three super asset classes:

• Capital Assets
• Commodities
• Stores’ of Value

Into the same asset for the first time with a bias towards low inflation.

2. ETH 2.0 Leverages Sharding to Scale the Network

Under ETH 2.0 the Ethereum blockchain will be divided into 64 parallel shards, which will each have a dynamic subset of nodes processing blocks of transactions. The reason why this is done is to ensure the demands to run a node remain low enough so that anyone can run a node using consumer hardware, while still increasing the scalability of the overall system. Sharding alone will scale throughput capacity by at least 64x greater than what is currently possible on the current PoW ETH chain.

Takeaway

Deploying sharding will scale Ethereum to Visa’s transaction throughput on the back of consumer hardware.

3. The Beacon Chain Ties PoS and Sharding Together

It is where all the system level activity and orchestration happens. The Beacon Chain stores and manages the registry of validators and their stakes, applies consensus rules, and stores references to shard states.

The Beacon Chain will be divided into slots-each of which is a chance for a block to be added to the Beacon Chain (and shards). Slots are further organized into epochs, which each contain 32 slots and serve as network checkpoints to help finalize transactions. In ETH 2.0’s end state, every 12 seconds one Beacon Chain block and 64 shard blocks will be added when the system is running optimally. Each block will be proposed by a pseudorandomly selected validator (block proposer) and will be voted on by a pseudorandomly selected committee of validators called attesters (target 128 per committee).

Takeaway

Decentralized scaling is a hard challenge ETH 2.0 has the chance to tackle successfully via the Beacon Chain.

4. Ether is the Heart of ETH 2.0

Finally, the heart of ETH 2.0 which makes the entire system possible, is Ether (ETH). ETH will not only be Ethereum’s native store of value asset, and fuel for transactions, but will also be Ethereum’s ultimate source of security from its role in the PoS system. Validators will be required to stake at least 32 ETH in order to participate in the consensus process. Validators will be rewarded for performing their duties adequately, penalized for failing to perform adequately, and slashed (have their stakes deleted) if they behave maliciously.

Due to the complexity involved in launching ETH 2.0 along with the fact that the community doesn’t want to cause any disruptions to the current Ethereum chain (ETH 1.x) which already supports a bustling economy, ETH 2.0 will be launched in phases over a multi-year period. ETH 2.0 will first run in parallel with ETH 1.x, theneventually merge with ETH 1.x by merging ETH 1.x into ETH 2.0 as a shard. These phases have been divided into Phase 0, Phase 1, Phase 1.5, and Phase 2. It’s important to note however, that despite the phases being numbered sequentially, the development of the phases will occur in parallel.

Takeaway

Ether the asset is critical to ETH 2.0:

• Transitioning to Proof of Stake From Proof of Work
• Operating Securely
• Merging ETH 1.x into the ETH 2.0 network
• Maintaining a low inflation rate

5 Key Principles of ETH 2.0

ETH 2.0 was designed with five key principles in mind: simplicity, long-term stability, sufficiency, defense in depth, and full light-client verifiability.

Simplicity-PoS and sharding are inherently complex. Simplicity allows ETH 2.0 to minimize development costs, reduce its attack surface, and clearly convince users that protocol parameter choices are legitimate because they’re easier to understand (key for credible neutrality).

Long-Term Stability-One of the dividing lines in the philosophy of blockchains is along the stability vs. evolution spectrum. The stability camp favors ossifying a blockchain so that it is more predictable to use and therefore, in theory, safer. It stems from the belief that stability is a necessity for any blockchain that truly wants to serve as critical public infrastructure, especially for things such as money. The evolution camp favors continually improving a blockchain so that it is more functional and robust. It stems from the belief that blockchain technology is in its infancy and there are many fundamental improvements to make before ossifying-evolution, for now, is critical. Ethereum so far has leaned more towards the evolution end of the spectrum, recognizing the infancy of blockchain technology and fundamental improvements it must make so that it can scale globally. However, ETH 2.0 is designed with the idea in mind that once built, there should be little need to change it for long periods of time, in order to achieve the stability necessary for Ethereum to serve as public infrastructure.

Sufficiency-While blockchains cannot be too powerful, as greater power implies greater complexity and hence greater brittleness, blockchains must still be powerful enough for it to be possible to build layer 2 protocols on top of it that are neither centralized nor reliant on strong trust assumptions. In order to achieve this blockchains must include an expressive(enough) programming language, scalable data availability and computation, and fast block times.

Defense in Depth-Blockchains must be fault tolerant and resilient to attacks they must work well under a variety of possible security assumptions. A key way to achieve this is to design the system so that it is as decentralized as possible to prevent faults, collusions and attacks, and in the case where harmful collusion does take place, make it extremely expensive for those colluding and easy for non colluding participants to recover the system. It is also important forparticipants validating the system to have skin in the game and for the system to hold individual contributors in a decision individually accountable for their contributions.

Full Light-Client Verifiability-Many users will only interact with the Ethereum blockchain through light clients-software that connects to full nodes in order to interact with the blockchain. Thus it’s important for those users to be able to be sure that given some assumptions they can verify that the data in the full system is available and valid, even under a 51% attack.

Takeaway

For ETH 2.0 to be successful it must:

• Make Understandable Design Choices
• Evolve into a stable foundation for other projects to build on
• Be sufficiently scalable via Layer 2 solutions
• Adopt a security model were validators have skin in the game
• Ensure data can be verified with off the shelf hardware

6. The Proof of Stake Model May Prove More Secure Than Proof of Work

economic-value-at-loss matters and may make PoS more secure than Pow, is because of how large that economic-value-as-loss may be. Unlike ASIC based PoW blockchains, like Bitcoin, which require upfront capital costs in the form of ASICs, the capital costs PoS participants putup do not depreciate. Furthermore, given the low maintenance costs stakers pay to run validators and the fact that stakers can get their deposits back at any time after a short withdrawal period, the only cost stakers truly incur is an opportunity cost. These points are important because they theoretically make PoS stakers more willing to pay higher capital costs per a dollar of rewards, perhaps by an order of magnitude or more, thus raising the cost to attack the chain substantially.

Takeaway

The primary POS cost is the opportunity costs for stakers versus the direct costs miners’ incur in the POW model.

7. Ethereum’s Monetary Policy is Defined as Minimum Necessary Issuance

the minimum amount of issuance necessary to ensure Ethereum remains secure. Although such a monetary policy may seem subjective and prone to spurious adjustments, like any protocol parameter, Ethereum’s monetary policy is enforced through social consensus. Any modifications to the monetary policy must be agreed upon by a wide range of stakeholders in the ecosystem-a feat that is far from easy. Since Ethereum’s mainnet launch it has only modified its issuance twice, with both adjustments being to reduce issuance to these estimated minimums.

Ethereum opts for perpetual issuance and an uncapped supply because it prioritizes security over monetary idealism. Unlike deterministically issued and fixed supply cryptocurrencies, whose security budgets have been arbitrarily set is pursuit of “perfect money”, Ethereum aims to issue enough ETH to ensure Ethereum remains secure now and into the future.

However, opting for perpetual issuance and an uncapped supply does not imply thatEthereum’s monetary policy will be highly inflationary and unpredictable.

Takeaway

Issuance of Ethereum is dictated by the security requirements of the network. To date its perpetual issuance policy has only been adjusted downwards never upwards.

8. The Beacon Chain is ETH 2.0’s Central Nervous System

that coordinates block production, manages the registry of validators and their balances, and applies consensus rules (including the issuance of rewards and penalties). Later on, it will also serve as the anchor point for each of Phase 1’s 64 shard chains.

Takeaway

The Beacon Chain is the foundation for ETH 2.0.

9. The First Step on the Path to ETH 2.0 is Staking

At a high level, Phase 0 is all about staking. The Beacon Chain’s arrival will enable ETH holders to become an ETH 2.0 validator and earn income on their staked ETH…

Phase 0’s sole purpose is to bootstrap ETH 2.0’s validator set and ensure that the network securely support the features introduced in subsequent phases. Despite its minimalist, almost testnet-like feature set, the Beacon Chain will have real financial opportunities and consequences for stakers…

The process of becoming an ETH 2.0 validator begins at the deposit contract…

a cross-chain communication solution to onboard stakers onto the Beacon Chain…

the deposit contract is unidirectional. Once ETH goes into the deposit contract, the only course of action is to claim ETH 2.0 ETH and stake. These staked assets along with any inflation rewards will be completely immoble for the foreseeable future since the Beacon Chain won’t be able to process transactions until Phase 1.5. ETH 2.0 researchers explored building a bidirectional bridge but determinedat too great of a risk should any issues on ETH 2.0 arise. Making the deposit contract irreversible was a safer approach that “allowed for a quicker development cycle on ETH 2.0.

Takeaway

For Hodlers willing to bear the illiquidity risk. The transition to ETH 2.0 starting with phase 0 represents a unique opportunity to earn a return on their ETH.

10. Beacon Chain Operates Via Epochs, Slots, and Blocks

From an architectural perspective, the Beacon Chain consists of epochs that break down further into slots. A slot is a 12 second window for a block to be added to the network, and an epoch is 32 slots, which amounts to six minutes and 24 seconds per epoch. In Phase 0, ETH 2.0 consists of only one chain, the Beacon Chain; therefore, slots will contain a single block. Once Phase 1 arrives and introduces 64 shard chains, slots will be an opportunity to add one Beacon Chain block and 64 shard blocks to the network. The first slot in every epoch generally serves as a network checkpoint, which helps finalize previously added blocks (make them essentially irreversible) and directs new clients towards the right chain in the event of a fork…

For each slot, the Beacon Chain uses a random sampling mechanism called a RANDAO to pseudorandomly select one validator to propose a block. It uses the same sampling mechanism to also pseudorandomly select a group (or multiple groups) of validators called attestors that will vote on the validity of the newly proposed block. Votes are weighed by an attester’s staking balance. A single group of attesters represents a committee, and each committee has a target membership of 128 validators.

Takeaway

You can only take simplicity so far to scale a decentralized network.

11. Rewards are Directly Tied to Validator Performance

The Beacon Chain uses an intricate system of validator rewards and penalties to avoid suboptimal execution while encouraging honest voting practices and high uptimes. Validators receive rewards for both producing and attesting (LMD GHOST and Casper FFG votes) blocks that receive supermajority support. Attestations for blocks that get finalized are worth even more. But missed votes or votes for blocks that don’t get finalized result in penalties (removal of staked balance) in proportion to the rewards they would have obtained for executing those responsibilities adequately…

Validators are rewarded for performing adequately, penalized for performing inadequately, and potentially slashed for behaving maliciously…

Takeaway

Block attestation is potentially more lucrative for validators than block production.

12. Yield is Driven by the Quantity and Quality of Validators

validators must… consider various costs.

Costs include capital acquisition costs (minimum 32 ETH needed to stake), opportunity costs (stakers are unable to withdraw their stake until Phase 1.5), and infrastructure costs (validator clients and beacon nodes)…

what will determine the headline yield is a combination of staking participation and validator uptime. The Beacon Chain needs at least 524,288 ETH staked to launch-at which point validators would be earning ~23% per year…

over time as users become more comfortable with the risks of staking, and service providers become better able to satisfy stakers needs (like liquidity), adoption should increase.

According to ConsenSys, the rate of staking participation for ETH 2.0 where it will match the security of ETH 1.x will be just under 16 million ETH. At this point validators would be earning a theoretical max of 4.4% per year. Although it may be a long time before that target is reached if at all before Phase 1.5.

Takeaway

What would be great for the beacon chain would not ber great for investors.

If a large group of quality validators deploying large blocks of ETH with high up-times are first in line to stake. The realized yields for early stakers may disappoint.

13. Enhanced Productivity From Transition to POS

More holistically, PoS will make ETH a significantly more productive asset than it was under PoW. On the current PoW chain ETH possesses store of value and commodity properties from its use as money and gas. On the new Beacon Chain, ETH will also possess capital asset properties from its use in PoS. Recall that validators are required to stake 32 ETH as collateral to register their node on the network in order to participate in consensus. In this capacity ETH will function as a type of hybrid-perpetual bond with debt and equity like characteristics. In return for behaving honestly and securing the Ethereum blockchain, stakers will be rewarded a perpetual, though variable, ETH-denominated yield derived from new issuance and transaction fees.

Takeaway

Adding capital asset properties to ETH increase its potential investor base. From making it attractive to those looking for instruments with perpetual yields to add to their portfolios.

14. Pending Tug of War Between Use Cases

In ETH 2.0, ETH will be both the most integral and productive asset in Ethereum’s economy. In ETH 2.0 ETH can be:

• Staked to produce yield for securing Ethereum
• Transformed into blockspace through transaction fees (an especially direct relationship when EIP 1559 is implemented and the majority of transaction fees are burned)
• Stored and transferred as Ethereum’s native (and thus most trust minimized) store of value asset.

The combination of the three may create a constant tug of war for ETH demanded by each use case. This will be especially apparent until Phase 1.5 considering that ETH deposited to stake will be locked, creating a temporary supply sink.

Takeaway

Demand from three use cases along with the temporary supply sink goes a long way towards explaining the recent price rise of ETH. While implying it could be a long way from being over.

15. Minimal Impact to Issuance From Beacon Chain Staking

Staking participation will likely start low and increase over time as holders gradually become more comfortable with the Beacon Chain and deposit more ETH into the deposit contract. What this means is that issuance could be extremely low in the early months following the Beacon Chain launch before reaching their theoretical maximums outlined in the above chart.

Takeaway

The level of participation in ETH 2.0 staking will not meaningfully impact Ethereum’s inflation rate until the merger with ETH 1.x in phase 1.5.

16. Defi Will Determine the Form Roll Ups Take

Ethereum may look very different a year from now. There could be one giant rollup that hosts all of the composability-reliant DeFi protocols (albeit at the expense of some scalability gains), while several others are more application specific and cater use cases like gaming, NFTs, or order book DEXs. The rate at which Ethereum transitions to this rollup centered framework depends on when (or if) the foundational DeFi building blocks like Uniswap or Compound make a move. Once these major protocols go, the rest are likely to follow.

Takeaway

Adoption of Ethereum’s roll-up centric future will be driven by making the leading Defi protocols comfortable with transitioning.

17. Scaling of Ethereum Starts in Phase 1

Phase 1 will unveil the network’s long-term scaling solution: sharding. Sharding involves splitting a blockchain into smaller, identical pieces, called shards, which each contain a subset of a blockchain’s nodes. A blockchain can then spread processing capacity across these parallel shards to increase the system’s overall transaction throughput, avoiding the need for each node to process and store every on-chain interaction…

Any communication between different shards occurs on an asynchronous basis, meaning that cross-shard transactions don’t happen all at once (essentially, in the same block).

Takeaway

Jeff Bezos famously said businesses trying to build lasting success should focus on what doesn’t change. All of the energy devoted to improvements in these areas will have a positive payoff for customers.

Blockchain user’s will always desire lower transaction costs and speedier confirmations. Phase 1 is when all of the energy Ethereum devs have devoted to building out Beacon chain meaningfully change these dimensions for users in a positive way.

18. Phase 1.5 Sunsets Proof of Work

Determining the optimal route for merging Ethereum into a single, unified network is the basis of Phase 1.5.

The integration of ETH 1.x into ETH 2.0 comes with two important implications. First, it officially marks the end of PoW and the point at which ETH 2.0 becomes Ethereum. From Phase 1.5 on, Ethereum will only use PoS to generate new blocks and validate transactions. The old PoW chain will continue to exist after the merge, but it will have a temporarylifespan since Ethereum developers have encoded a function (called the difficulty bomb) that will make mining permanently impractical at a future block height. Second, Phase 1.5 realigns Ethereum as a single network with one native token, which will allow the Beacon Chain and shards to safely unlock transactions. Once transactions are live, Beacon Chain validators will be able to withdraw their staking deposits and rewards for the first time.

Takeaway

You’ll finally get your ETH back when phase 1.5 is implemented.

19. Phase 1.5 Usher’s in an Era of Disinflation

As detailed in the Phase 0 section, issuance from the Beacon Chain will be incremental to issuance from ETH 1.x. This will cause overall ETH issuance to increase slightly until Phase 1.5 when ETH 1.x is merged into ETH 2.0 as a shard chain. However, when the merger is complete, the once incremental issuance from ETH 2.0 will become the only issuance for Ethereum, and it is very likely Ethereum’s annual issuance rate will be well below 1%.

Plotting these above analyses on a time series chart illustrates how significant the drop in annual issuance rate will be once ETH 1.x merges into ETH 2.0. At this point Ethereum’s annual issuance would be well below Bitcoin’s annual issuance rate of 1.7%.

Takeaway

Ethereum’s inflation rate will drop ~75% when phase 1.5 is implemented. As the 3.99% POW inflation rate disappears and the long term inflation rate required to support staking settles around 1%.

20. Competition for Stakers

One potentially important dynamic that will be present in Phase 1.5 that will not be in prior phases is the competition between staking and DeFi yields…

Luckily, ETH 2.0’s monetary policy is adaptive and has a self-correcting negative feedback mechanism that prevents staked ETH from falling too low…

if deposits fall extremely low reward rates rise extremely high to incentivize more people to stake. Further mitigating this effect is that stakers will likely not face a binary decision on whether to stake or lend their ETH in DeFi. The existence of staking derivatives will allow stakers to get additional productivity on their staked ETH through rehypothecation.If yields in DeFi are high, stakers may potentially be able to take advantage of those yields through putting their staked ETH derivatives to work in DeFi…

Takeaway

ETH 2.0 has mechanisms in place to attract enough stakers to ensure the network is secure. If it is forced to directly compete for stakers with the high yielding platforms built on top of it.

But, via the financial wizardry of rehypothecation. The more likely outcome is stakers will double dip. Earning a direct yield on their ETH via staking and an indirect yield by leveraging ETH derivatives to take advantage of Defi yield opportunities too.

21. ETH 2.0 Displays Characteristics of Both Debt and Equity

Phase 1.5 furthers transformation of ETH as an asset,adding two key additional features to staking:

• The ability to withdraw your stake and claim rewards

• The opportunity to earn transaction fees

Staking provides ETH with bond-like characteristics in that it is a type of digital agreement where Ethereum acts as a bond issuer and stakers act as bond holders. Just like a typical vanilla bond, stakers provide capital up front to Ethereum and Ethereum pays stakers periodic rewards. The major difference is that stakers can redeem their ETH back on command as opposed to having to wait until a maturity date. This feature is similar to an embedded put option on the bond that provides the right, not the obligation, to demand early repayment of the principal…

Ethereum’s bond-like characteristics are only half the picture. Two key features that make ETH equity-like as well are its perpetual nature and its claim on Ethereum’s transaction fees.

Takeaway

ETH 2.0 displays unique investment characteristics. Investors can gain exposure to a perpetually issued asset while collecting a bond-like income stream and can redeem said asset whenever they wish.

22. Phase 2 is a Hedge

Phase 2 is still on the roadmap, and is still being worked towards, but there’s a possibility Ethereum eventually accepts a “phase 1.5 and done” approach. ETH 2.0’s long-termfuture would instead be as a single high-security execution shard that everyone processes, plus a scalable data availability layer…

If Ethereum’s “rollup-centric future” strategy is successful, as discussed in the Rollup-centric Ethereum section above, it could replace the need for Phase 2 and lead Ethereum to accept a “Phase 1.5 and done” approach. The less extreme scenario is if only a few shards (in the 4-8 range) become smart contract executions layers while the rest remain data containers for rollups. Either way, with rollups stealing the spotlight, the Ethereum Foundation has “deemphasized” development efforts on Phase 2 as it is no longer a priority.

Takeaway

If Phase 1.5 meets expectations the Ethereum Foundation may not move forward with Phase 2. The Foundation is not assuming this happens and continues to operate as if Phase 2 development is needed.

23. What Lies Beyond Phase 2

Ethereum’s development efforts won’t completely halt evolution after Phase 2 (or Phase 1.5, whichever comes first). The ETH 2.0 roadmap includes several more advanced features that developers, and if by consent, the community, would like to add to Ethereum’s skeletal infrastructure further down the line…

Polynomial commitments are one of several “Beyond Phase 2” research effortsthat focus on making Ethereum more data efficient. They aim to replace the use of Merkle trees to dramatically reduce storage requirements on network clients…

Ethereum will eventually require an upgrade to its smart contract execution layer (also referred to as a virtual machine or VM). In their eyes, the ideal successor to the EVM would be zk-SNARK or STARK friendly virtual machine…

zk-SNARK and STARK friendly VMs would extend this privacy preserving capability to smart contract execution, enabling developers to build and run applications without revealing the actual code. Any transactions that flow in and out of these applications would also remain private…

Ethereum’s radical transparency is a valuable asset, in that every inch of code and every transaction are fully auditable. But a fully transparent blockchain where any user could surveill another user may change the relationship between the surveilling user and the surveilled user by the simple fact of a user knowing they are being observed.130 Privacy is important in ensuring the most powerful users don’t interfere with weaker users’ pursuit of self sovereignty…

In the distant future, Ethereum could look to upgrade its Proof of Stake (PoS) algorithm from Casper FFG to CBC (Correct by Construction) Casper…

Despite its complexity, CBC Casper remains on the Ethereum roadmap because it offers some clear advantages over Casper FFG in terms of finality and flexibility.

Takeaway

Even after the exponential leap forward of ETH 2.0. Many additional projects are planned to maximize Ethereum’s potential and secure its future.

Original notes these takeaways are from.

Further Reading

Lessons To Be Learned from Zero to One