Tokenization and ERC20 tokens on Ethereum 2.0: All you need to know

Tokenization and ERC20 tokens on Ethereum 2.0: All you need to know

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Ethereum 2.0 is about to be launched and it brings high expectations for scalability and a switch from Proof of Work to Proof of Stake. At the same time, many wonder what impact the updates will have on ERC20 tokens and dapps that currently operate on Ethereum. 

The changes on Ethereum will have consequences for users and developers. As you may know, Ethereum 2.0 will be implemented over several phases. The first phase (phase 0), is already defined and practically fully implemented, just a few small details and some testing are pending. But, as we look at newer phases, we start entering  into environments that are more focussed on research than on engineering. That is why a lot of consequences of Ethereum 2.0 aren’t clear yet. 

In this post we’re going to explain the consequences of Ethereum 2.0 for tokenization and for ERC20 tokens that already exist on the Ethereum network. To explain its impact, we have used as a reference its specification in those phases that are already defined. For the more advanced phases (basically, 1.5 and 2), we will use as a reference the most advanced research, but it’s likely that there will be changes once there is a specification available. 

This post will be updated based on the advances of the specifications of the phases of Ethereum 2.0. As usual, any feedback or suggestions are more than welcome.

Visual representation of the Beacon chain. Source. Simulator
One chain to rule them all. One chain to coordinate them. One chain to validate them all and under consensus finalize them.

Phase 0

When phase 0 starts, Beacon chain will be incorporated as the first element of Ethereum 2.0. This means that the transition to Proof of Stake will start, although this transition won’t be completed until a later phase. During this initial phase, POS and POW will both operate in parallel. The blockchain of Ethereum 1.0 will continue to operate without any changes. It will work independently from the Beacon chain, that will read the blocks that will be generated on Ethereum 1.0. The smart contracts will remain in their place and the EVM will be in charge of their execution. 

How will this phase affect tokenization?

Neither users nor developers should notice any changes. Everything related to ERC20 (or similar) tokens will continue to occur in the same place and in the same way. 

Phase 1 

Phase 1 means the arrival of sharding to Ethereum. This means that up to 64 “blockchains” (shards) will start to operate and to be synchronized and validated through the beacon chain. Although there will be a variety of blockchains coexisting, these won’t count with a virtual machine to execute smart contracts, so that they will only serve to store data. The blockchain of Ethereum 1.0 will remain to operate separately during this phase.

How will this phase affect tokenization?

Again, neither users nor developers should notice any difference. However, the increase of data available will probably lead to the use of scaling solutions based on Layer 2 between applications that generate a huge amount of transactions of tokens per second (such as decentralized exchanges and games). These solutions aren’t new, in fact, they’re being used today on Ethereum, however, on a minor scale. 

Phase 1.5

At a certain point after phase 1, it’s expected that the blockchain of Ethereum 1.0 will be migrated to the new Ethereum 2.0, converting Ethereum 1.0 in a shard within Ethereum 2.0.

The exact way this migration will be done hasn’t been defined yet, but it’s in active research. However, most likely the state of Ethereum will be copied and saved in a shard with the same virtual machine. In that moment, it will be the only shard with a virtual machine. The rest of shards will remain to be used just to store data. 

This moment will mark the end of Ethereum 1.0. The only consensus mechanism that will govern Ethereum will be the Proof of Stake from the Beacon chain. Proof of work will stop to function.

How will this phase affect tokenization?

At this point, changes will be noticeable when ERC20 tokens are used, as the transactions will be faster. The change to Proof of Stake implies that the block time is fixed to 12 seconds. This will make it a lot more comfortable to develop dapps. The scalability solutions based on Layer 2 will also work better. 

Phase 2

Phase 2 will complete the transition to Ethereum 2.0. Here’s when we will notice the most changes as users and developers. This phase partially still has to be defined. What we do know for sure is that by phase 2, the shards will have their own virtual machine (eWASM) and there will be multiple Execution Environments. How this will be done has not been defined yet. 

The smart contracts and the execution load will be distributed among the shards, but not in an equal way. The transactions within the same shard will continue to be efficient, but when it occurs that a transaction executes functions from a variety of smart contracts in different shards, the efficiency and the user experience won’t be as good. This will probably lead to dapps from the same type that interact with each other wanting to concentrate in particular shards, while other types might prefer to isolate. For example, all the DeFi apps will most likely use the same shard where the interaction between them is quick and cheap. However, a social dapp or a game that don’t need to interact with other smart contracts outside of the application itself, probably prefers to go to another shard less crowded and take advantage of a lower gas price. 

How will this phase affect tokenization?

On one hand, the inclusion of the Ethereum WebAssembly (eWasm), a new virtual machine that is more efficient, will lead to lower transaction costs. But, on the other hand, we will have the problem that comes from cross-shard transactions.

The current ERC20 tokens consist of a smart contract with a registry of balances that allow transactions between users. With the migration of phase 1.5, these smart contracts will be allocated in the same shard on Ethereum 2.0. In the second phase, if you continue to use the tokens and interact with dapps within the same shard, you shouldn’t be noticing any difference to phase 1.5. However, as time passes, more and more dapps will be migrating to, and be created in, other shards. Interacting between shards with a current ERC20 token will be a problem. The transactions will be slower and more expensive. The user experience and the development of smart contracts will be affected. 

Taking the above into account, it’s clear that the ERC20 tokens as they’re today won’t operate well once the transition to Ethereum 2.0 has been completed. One of the proposed solutions would be deploying a smart contract similar to a ERC20 in all the shards. These “ERC20 2.0” would communicate with themselves among shards to synchronize the balances, so that when you want to use your tokens in another shards, first you’d have to indicate to the token to which shard you want to send it to, so that it can prepare itself.

This solution could also be applied to tokens that are already deployed on Ethereum 1.0 by creating smart contracts that wrap a token and add these properties. Something similar to what WETH does with ETH. 

Post Phase 2

It’s true that when we speak about Ethereum 2.0, we normally refer to the phases 0, 1 and 2, which is when the new blockchain gets completed. However, the development of Ethereum won’t stop there. There are more updates and solutions for scalability planned on a theoretical perspective. But those new updates are as for now too speculative, that’s why for this post, we didn’t want to go beyond phase 2.

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