Ethereum has been getting ready to "merge," creating temporary disruptions in some crypto trading and potentially new opportunities for investors.
Now the Merge has finally happened.
But what does it really mean?
In simple but perhaps poorly understood terms, Ethereum has gone from a cryptocurrency token backed by a proof-of-work blockchain to one supported by a proof-of-stake blockchain.
This process required the help of a proof-of-stake chain called Beacon, which had been developing in parallel with the Ethereum blockchain since 2020. Though Beacon did not formerly process transactions, it had acted as a testing ground that allowed for a smooth transition to the PoS upgrade.
Full transition to PoS required that Ethereum’s PoW mainnet, or Execution Layer, merge with Ethereum’s Beacon Chain, or Consensus Layer.
“The best diagram I’ve seen looks sort of like what you see in subway stations,” said Richard Smith, CEO of fintech investing tool RiskSmith and a specialist on market risk and uncertainty. “You have maps of subway lines, and sometimes two lines run in parallel and one line kind of ends at a common station and everybody who was on that line has to move over to the line that continues on if they want to go further. That is, in a nutshell, what happens to Ethereum when the Merge occurs.”
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The problem with proof-of-work
Like Bitcoin before it, Ethereum was built upon a proof-of-work blockchain in which transactions are verified by a network of computers working to solve cryptographic problems.
While a proof-of-work blockchain can create a secure, highly dispersed network of miners who are compensated for the work of their computers with tokens, it also requires a very high level of energy expenditure.
At the same time, the heavy energy drain of proof-of-work blockchains was a feature, not a bug, according to Omid Malekan, a Columbia Business School professor, crypto expert and author of "Re-Architecting Trust: The Curse of History and the Crypto Cure for Money, Markets, and Platforms."
“The goal was to be able to control who is updating and curating a digital ledger while still being decentralized,” Malekan said. “So mining was an ingenious and complicated solution involving volunteers who proved their honest intent by wasting money consuming energy. The energy has nothing to do with running the blockchain, it’s a way of using a financial incentive to net out an honest outcome that can lead to a secure system. And it has worked.”
How proof-of-stake will work
In a proof-of-stake blockchain, participants can loan their tokens to the network and earn a yield on their money. In Ethereum’s case, after the Merge anyone with at least 32 ether (ETH) tokens can establish themselves as a validator on the token’s network and earn a yield of 5%-10%.
Instead of making people burn untold amounts of electricity, proof-of-stake makes network participants put some of their money in what is essentially escrow to prove their honest intent.
The transition greatly impacts the risk-reward characteristics of Ethereum. Being able to generate a guaranteed yield from Ethereum removes some of the market risk of the investment, according to Smith.
At the same time, there is still capital at risk. “You can’t think of it like a CD where at least you know you’ll get your principal back,” Smith said. “You have to ask whether it’s worth 4%-5% to bet on the price of Ethereum now.”
Drawbacks of proof-of-stake
Despite the potential benefits of proof-of-stake, especially decreased energy usage, there are at least a couple caveats.
For starters, there’s still some degree of debate over the consequences of the new energy expenditure. With the Merge, there may or may not be a lower environmental impact from Ethereum and it’s not really clear whether that will actually happen, according to Malekan.
Also, a frequent critique of proof-of-stake blockchains is that they are too easy to corner. If a large investor stakes a large number of transactions early in the blockchain’s existence, they can dominate the staking and verification functions on the network, which theoretically could provide vulnerabilities for bad actors to exploit.
Similarly, proof-of-stake blockchains can also be inherently centralizing. Large investors can get into networks early, stake the largest sums of currency and then get more income than anyone else.
That said, in Ethereum’s case, starting with a proof-of-work protocol allowed its network to grow and expand to the point where it is not easily dominated by any one person or group of actors.
Alternatives to proof-of-stake
Smith believes there are other solutions to make energy-heavy, proof-of-work blockchains more efficient.
One example is Bitcoin Satoshi Vision, or BSV. BSV is a descendent of the Bitcoin blockchain. Bitcoin forked and created Bitcoin Cash, or BCH. BCH later forked again, creating BSV. BSV reduces energy costs by increasing the block sizes that miners work through. The trade-off is that participants in the BSV network have to make a much larger investment to be miners.
The advantages of proof-of-stake
A couple aspects of the transition to proof-of-stake could add value to the Ethereum network and its token over the long term and attract investment.
First, despite any debate of environmental impact, there could be a clear monetary impact from the transition.
“What will happen is a significant drop in Ethereum inflation in part because you’re no longer having people waste billions of their dollars on electricity,” Malekan said. “Thus, you don’t need to mint as many coins to reward them for their work. And this makes Ethereum more appealing to many institutional investors because staking is something anyone can do.”
Moving to proof-of-stake may also make it easier for layer 2, or companion blockchain, products to be built on the Ethereum blockchain, which over the long term could increase the value of the network and its token, according to Malekan.
But, like it or not, the Merge has happened. And only time will tell exactly what the immediate and long-term consequences of it will be.
“Ethereum is taking a different approach, and it’s definitely an experiment worth running,” Smith said.