Ethereum Shanghai Update: A Bold Step Towards the Future or a Risky Jump Off the Cliff?

Today, Ethereum is the second most popular cryptocurrency on the market, thanks to its sophisticated consensus algorithm and innovative solutions that have underpinned its blockchain network. The history of updates to Ethereum includes dozens of hard forks, which in one way or another, have been aimed at reducing transaction fees, improving the stability of the distributed ledger, and upgrading security and smart contract protocols. The Shanghai update was the last and perhaps the most important after The Merge (or Ethereum 2.0 update).

This article will explain Ethereum's Shanghai update, the opportunities, the implications it brings to the network, and the risks and vulnerabilities. In the end, you will learn about the prospects for the Ethereum project after receiving the Shanghai update.

KEY TAKEAWAYS

What is Ethereum's Shanghai Update?

Ethereum's Shanghai upgrade is a hard fork and a major enchantment of the Ethereum ecosystem that could affect the market value of the ETH cryptocurrency, as stakers and validators can now withdraw ETH from the Beacon Chain deposit contract. This change makes the network complete in terms of PoS consensus mechanism, allowing ETH users not only to stake coins but also to withdraw them into liquidity if necessary.

The Shanghai update pack influences Ethereum's so-called execution layer, the network component that deals with smart contracts and protocol rules. Another set of updates, dubbed Capella, will apply to Ethereum's consensus layer – the part of the network through which Ethereum's validators enforce rules set in the execution layer. Both updates take place simultaneously, and the Ethereum developers have combined them under a single name - Shapella.

This massive unlocking of coins marks the final phase of Ethereum's most significant update, called The Merge, after which the network has moved to a Proof-of-Stake (PoS) transaction validation algorithm. According to the algorithm's rules, new ETH is distributed as a reward to those who hold staked coins. The more ETH a blockchain validator places in staking, the more likely the Ethereum network to validate transactions and reward it with new coins.

To motivate validators to keep the network running, a staking fee of up to 5% per annum is paid to anyone who deposits coins in a special smart contract as collateral. The contract is called the Beacon Chain and was launched in 2020 when the issuance of new coins in Ethereum came at the expense of mining. Last September, developers successfully migrated the network to the PoS algorithm. Still, institutional investors with coins locked into the Beacon Chain could technically not withdraw funds – both collateral and accrued income in the form of rewards. The Shanghai upgrade solves this problem. Once it launches, about 500,000 validators can withdraw a minimum pledge of 32 ETH (about $57k) and accumulate rewards as new coins.

FAST FACT

The Shanghai update is an important preparatory step before the development of a series of solutions aimed at implementing the Ethereum 2.0 update

Opportunities and Implications of Ethereum's Shanghai Update

The long-awaited Shanghai update is a watershed moment for the ETH blockchain in many ways, comparable in scale only to the recent Ethereum Merge update. It is believed that this upgrade not only redefines the concept of the project regarding staking and lending but also helps to increase the investment appeal many times over thanks to the numerous Ethereum improvement proposals.

According to the EIP (Ethereum Improvement Proposal), which describes and proposes changes to the Ethereum protocol to improve its functionality and efficiency, among the most important changes are the following:

• EIP-4895: Beacon Chain Push Withdrawals as Operations

This ETH update offer provides validators with the ability of partial withdrawal of ETH that has been added to the staking on the Beacon Chain since December 2020, when the network was originally introduced. EIP-4895 offers long-term stakers and holders additional liquidity by allowing staked ETH to be withdrawn from staking with low gas fees after a two-year wait. This innovation is perhaps the most anticipated of any available within the Shanghai package, especially for holders of large amounts of Ethereum in their accounts.

• EIP-3855: PUSH0 Instruction

This proposal updates the set of instructions and rules for the Ethereum Virtual Machine (EVM), which significantly reduces the size of smart contracts and optimizes code. The EVM object format puts the data for a smart contract into one set of codes and separates it from the rest of the smart contract code. The smart contract interacts with the data through calls and queries. This format is expected to add flexibility to Ethereum smart contracts and increase the speed of their queries, as well as reduce the gas fees charged for these transactions.

• EIP-3860: Limit and Meter Initcode

EIP-3860 is an EIP-170 extension that limits the maximum initialization code size to 49152 and provides a fair initialization code charge when interacting with an “initcode”, thereby reducing the transaction fee. In addition, this change adds two additional units of gas for each 32-byte portion of the code. This solves the problem of gas shortage exceptions in Ethereum, which has persisted for years. Thanks to such solutions, it will be possible to achieve significant improvements in blockchain efficiency and reduce its load, which often leads to delays in various operations within the network.

• EIP-3651

This update aims to improve Ethereum's interaction with the Coinbase cryptocurrency exchange and wallet. Payments from the U.S. platform are now more expensive than from other similar projects. The initial interaction with Coinbase software requires “warming up” because it consumes more gas than regular transactions.

This is because, under the access list structure introduced by EIP-2929, Coinbase calculates gas according to the cost of accessing a “cold” account in EIP. With the implementation of EIP-3651, the wallet software will be “warm” from the start, reducing the exchange's gas consumption when paying with ERC20 tokens.

Risks and Vulnerabilities of the Shanghai Ethereum Blockchain Update

The Shanghai Ethereum update is a long-awaited change to the Ethereum Proof-of-Stake (PoS) consensus mechanism. Before the update's launch, developers scheduled test networks with Sepolia, the second-largest test network that provides a secure and reliable environment for testing smart contracts features. Only authorized individuals can run validation nodes on Sepolia's new consensus level. The update allows users to withdraw tens of billions of dollars in ether. With the update, there are some risks to consider, especially if you have ETH staked somewhere.

• Staked Ethereum Volume Decline

According to research by CryptoQuant, about 60% of the assets locked up in staking contracts (about 10.3 million ETH) are now unprofitable (if you compare the current price to the price at the time each token was placed). A significant number of unprofitable tokens were locked in between March 2021 and June 2022, when ETH was trading above $2,000. Meanwhile, most of the remaining profitable ETH rose only 20-30%. In other words, it's simply not profitable for stakers to sell their ETH now.

Moreover, 75% of staked Ethereum is controlled by crypto-exchanges (Coinbase, Binance, Kraken), which allowed investing in staking any amount, and special platforms (Lido, Rocketpool, Stakehound, Stakewise, Stkr), which provided their users with liquid staking services – issue of “derivative” token (derivative) secured by cryptocurrency blocked in staking. It turns out that most private stakers will not be able to directly initiate a withdrawal. And when you consider that almost all the big players are at a loss, they won't be in a hurry to do so either. So, all that's left for us to do is to see how successful the renewal is. In our opinion, Shanghai is another step for Ethereum to achieve global mass adoption and secure its status as a true industry engine.

• Impact on the Ethereum Price

The complete withdrawal option will reduce the number of validators in the network, but the intensity of this effect depends on the number of validators using this option. The Beacon chain's totally blocked value (TVL) may be depleted as stakers claim their staking rewards and give up their assets.

How this affects the Ethereum price depends on what most validators decide to do with their rewards and uninvested assets. The market is incredibly difficult to predict, and popular assumptions may not work. However, there is a daily withdrawal limit to limit the update's impact on the market price of Ethereum.

• Impact on Other Market Tokens Price

In addition to ETH, Shanghai update Ethereum can also significantly affect the tokens of liquid-staking services such as Lido, Rocketpool, Stakehound, etc. These platforms issue Liquid Staking Derivatives (LSD), tokens representing staked Ethereum. Thanks to them, any amount of money can be invested in ETH staking, which will not be blocked under any circumstances.

After the Shanghai Ethereum update, the value of these platforms' native tokens may also change. And it will most likely be directly correlated with ETH (if ETH price goes up, LSD tokens will go up too). Still, with more dynamics, especially in case of decline – ETH is interesting by itself, while LSD is interesting only if the currency underlying their derivatives grows.

Ethereum Prospects: Will the New Update Give the Project a Boost or Collapse its Price?

The new update of Ethereum has become a widely discussed event that has undoubtedly changed the course of things within the concept of its blockchain development. Some experts argue that due to the latest update and the sharp decline in staked coins, the price of ETH digital assets could plummet, affecting the state of altcoins. On the other hand, many experts point out that thanks to the renewal of Shanghai, the coin will be able to renew not only the annual price highs but also set new records in the nearest future, despite the insignificant and short-term outflow of funds due to the withdrawal of blocked coins by the validators. Anyway, it’s possible to expect two scenarios.

• Ethereum Price Rising

The main factor influencing the price of ETH is staking. Thanks to the Shanghai network update, more users will hold and contribute their ETH to staking, which favors the price increase. Ethereum's staking ratio will rise due to the ability to withdraw ETH because investors who previously worried about their money could earn higher returns without experiencing a drop in liquidity. As a result, we should expect ETH's price to increase so long as big institutions continue to acquire ETH and add it to their stakes to earn 5% APY without sacrificing liquidity.

Ethereum's Shanghai update will address several urgent user and developer issues, from lower gas fees to fewer transaction errors. The Ethereum Foundation also promises little to no delays in the buildup to the Surge release because these changes will be implemented before the next Ethereum upgrade EIP-4844: Proto Danksharding update is made available.

• Ethereum Price Fall

As a result of the Terra Luna and FTX collapses, there is still a gloomy feeling in the crypto industry, and significant businesses are failing. Another way to characterize macroeconomic issues is as pessimistic, given that the Federal Reserve is still raising interest rates and that U.S. inflation is still well below the 2% target. Due to the possibility of a bear market, this may compel the initial users who started ETH staking in December 2020 to sell their ETH and obtain greater liquidity. This is why the Ethereum Foundation implemented a daily withdrawal cap of about 40,000 ETH, which should lessen selling pressure and lower ETH's volatility in the short term.

It is assumed that the Shanghai upgrade, among other things, will affect how institutional investors will interact with the coin. On the one hand, we can assume that private investors will be more willing to invest their money knowing that new updates plus Bitcoin's dominance always grow exponentially, and over time the investments will bring good returns.  On the other hand, liquidity providers will be more willing to invest their assets in ETH liquidity pools, knowing that they can access them and cash them out at any moment.

Conclusion

Shanghai update was undoubtedly one of the most significant upgrades in the history of the crypto project Ethereum, which today is a kind of technological basis for developing new decentralized applications working with the help of smart contracts. It is one of the most promising cryptocurrencies on the market, with great potential to become a benchmark of quality blockchain solutions developed for practical use in different areas of the financial system.