While Ethereum has brought about a whole new realm of possibilities due to its native token Ether (ETH) and its smart contract and tokenization capabilities, it is often faced with challenges such as network congestion, relatively low transaction times and throughput, large blockchain size and excessive electricity use for mining — all issues Bitcoin also shares.

While Bitcoin (BTC) was created by an anonymous developer that left the network to be developed by its capable community, Ethereum was always envisioned with a roadmap and a team behind it. While the plan has been subject to changes and delays, Ethereum has always meant to implement certain measures to combat all of the aforementioned issues, much like the developer community has done with Bitcoin and updates such as Segregated Witness.

Ethereum was created in several stages, many of which have been implemented, but Serenity — or Ethereum 2.0 — is particularly important for the network and community because it will bring about some of the biggest changes in the network, including proof-of-stake and sharding updates. With the Ethereum network use falling so heavily on the decentralized finance and distributed application ecosystem, many wonder what will happen to the DeFi ecosystem as the Ethereum 2.0 update is rolled out.

What is Ethereum 2.0? 

Ethereum 2.0 is set to launch in the second half of 2020, following its announcement in 2018 and launch delays in 2019 and 2020. The first stage is currently known as “Phase 0” and will see the launch of the Beacon Chain, the blockchain on which the first iteration of Ethereum’s PoS consensus model will be implemented. The second stage, “Phase 1,” will bring the implementation of shard chains that are compatible with each other and can be used simultaneously.

Related: Ethereum 2.0 Staking, Explained

While these two stages will build the foundation of Ethereum 2.0 and the solutions for the congestion and scalability issues Ethereum is currently facing, these two stages will coexist with the current blockchain, and the two will only be merged in the third stage, “Phase 1.5.” Ethereum will coexist alongside 63 other blockchains, with the aforementioned Beacon Chain eliminating the need for token swaps for those that wish to remain on the original chain throughout the implementation of Ethereum 2.0.

Once Ethereum 1.0 is “merged” with Ethereum 2.0, the blockchain history will remain, with Ethereum 2.0 being considered “complete” when Phase 2 and beyond are released, which is expected to happen by 2021. Until then, the proof-of-work consensus model will continue to be supported and developed to ensure a stable basis for DApps and DeFi before the jump from a single-chain PoW protocol to a multichain PoS system is made.

How urgently is Ethereum 2.0 needed?

Ether is the second-largest cryptocurrency, but it is currently only capable of processing 15 transactions per second. Moreover, gas use and limits create a fee market where people must often compete for transactions and smart contracts to be processed quickly by paying higher gas prices. NEO, for example, is theoretically capable of processing 10,000 transactions per second, which means Ethereum has some catching up to do.

While increasing the gas use limit is possible and was enabled in September 2019, it comes with a heavy toll, as it further extends an already big blockchain. Ethereum’s blockchain is currently 142 gigabytes, and while Bitcoin’s chain is bigger, just 283 GB have been mounted on after more than 10 years of blockchain history. This makes the Ethereum chain, which is less than five years old, almost as resource-intensive as Bitcoin, and the issues are only bound to get worse as the DeFi ecosystem expands.

So, it seems that Ethereum is in desperate need of new solutions. While some are being developed alongside Ethereum 2.0, such as Plasma and Raiden — the official Ethereum 2.0 and other layer-two solutions — Jon Jordan, the communications director at DappRadar, told Cointelegraph that these come with a certain degree of risk:

“Of course, issues such as gas prices can be solved without Eth 2.0 There are plenty of layer 2 solutions launching and available - Matic, Skale Labs, OMG Network etc - which would solve these problems to some degree. And dapp developers are actively integrating these technologies or attempting to build their own. However, all these add potential risk. Eth 2.0’s advantage is it’s core to the underlying blockchain but for that reason it’s a more complex task.”

Transition period: Can DApps adapt?

When Phase 0 is launched, users that want to stake Ether will have to send their coins to a one-way smart contract. This means that the Ether that leaves the current network during Phase 0 will only be usable on the old blockchain once the Phase 1.5 “merger” happens — at which time the PoS and chain sharding features will already be a reality for all of Ethereum.

Jack O’Holleran, the CEO of the Skale Labs — the company that developed the Skale Network blockchain platform based on Ethereum — previously explained that the shift to Ethereum 2.0 will take time for DeFi and DApps, as most will probably wait until the merger and then take time to transition “at their leisure.”

This transaction period between the current version of Ethereum and Ethereum 2.0 doesn’t seem to be a major concern in the DeFi space. Jordan stated that this period will probably not impact DApps directly but that “any uncertainty or technical issues arising could slow activity” — so, it’s still worth considering.

Ethereum 2.0: Advantages and dangers

Upon full completion, the PoS system will likely affect DApps, particularly in the DeFi space, with the change bound to bring improvements to the whole ecosystem, allowing ETH transactions and DApps to compete with other blockchains. According to Jordan, the sharding chains and PoS consensus model will solve some of the most fundamental issues of DApps.

The sharding feature on Ethereum 2.0 will allow 64 chains to run in parallel, meaning that the transaction speed and throughput will be considerably increased. These chains will be interoperable, and users will be able to spend Ether across multiple chains. However, the burden of keeping the blockchain history will be distributed throughout the multiple chains, allowing the network to be more accessible while still secure and supporting legacy DeFi functionalities, as Stani Kulechov, a CEO at Aave — an Ethereum-based DeFi app — said in a conversation with Cointelegraph:

“ETH 2.0 will change the dynamics of DeFi in one way as we might see less congestion with transactions in DeFi and potentially the staking model might reduce the costs of transactions. Main thing about sharding is that it should not break the DeFi composability according to Vitalik Buterin.”

All of these improvements have a huge impact on DApps, especially in the long run. As the Ethereum ecosystem develops, more DApps and more people using them means that more resources will be needed. Sharding solves this issue to a degree, and as other solutions are implemented, the community can continue to invest time and resources into the DeFi and DApp space without fear of “technical debt.”

It is still worth noting, however, that while Ethereum 2.0 seems promising for the DeFi space, it is not without its risks, which is why developers are still working on the development of Ethereum 1.0 even as Ethereum 2.0 is being rolled out, as Jordan stated:

“In this context, the advantages offered by Eth 2.0 greatly outweigh the risks. Unlike Bitcoin, which is never going to change much, if Ethereum wants to fulfil its vision — as well as competing with new rivals like Cardano, Flow, Near etc etc — it needs to fundamentally change. But this isn’t to say there aren’t any serious risks. It’s highly unlikely but, handled badly, Eth 2.0 could destroy confidence in the entire project!”

How will staking affect DeFi?

Although sharding and PoS bring obvious benefits to the network, the latter will change the way Ether is produced. Staking will allow anyone with 32 or more ETH to earn new coins by staking theirs, which adds a penalty system for any malicious attempts on the network while rewarding those that process transactions accordingly.

Related: Ethereum 2.0: The Choice Between One’s Own Node and a Staking Service

While there are arguments for and against the PoS model, it’s worth noting that this system resembles lending — the most popular application for DeFi apps — in its most fundamental manner, as users will lock their ETH in order to receive interest. With this in mind, a pertinent question arises: Can these two aspects coexist in Ethereum? Won’t the most profitable take the least profitable activity’s place? According to Jordan, this isn’t likely to happen:

“Staking and lending aren’t mutually exclusive actions. In the short term, I’d expect some value that would otherwise have gone into lending and DeFi dapps to go into staking but most of the value going to staking will come from large scale crypto operators to secure Eth 2.0. These value flows would never have gone into DeFi. I guess what will be exciting to see if/how dapp developers look to combine Eth 2.0 staking mechanics within DeFi dapps for the smaller retail users.”

Piecing it together

While Ethereum is currently in need of urgent solutions for its congestion issues among others, it’s also worth noting that Ether is still the largest altcoin out there. This begs the question of how well it can do once Ethereum 2.0 is implemented and its capabilities improve substantially. Some also believe that staking itself can trigger an ETH price rally.

Whatever the price may be in the future, Ethereum 2.0 is very important for the DeFi ecosystem, but it needs to be done right to ensure it does not interfere with one of its major ecosystems: the DeFi space. As Kulechov put it: “It’s better to build a valid system that works well in practice than launch something that requires changes after deployment.”