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The blockchain that underpins the Ether cryptocurrency has just been made more energy efficient, secure, and scalable.
Andrew Pilott explains how it was done, the market and regulatory reaction, and likely future developments.

Ethereum, the blockchain that powers the cryptocurrency Ether (ETH), has updated its system in a move known as “The Merge”. On September 15, it moved from a proof-of-work mechanism to verify transactions to a proof-of-stake mechanism which it says will reduce its energy costs by 99.95% and make the network more attractive to users.

The upgrade has been widely welcomed by exchanges, investors, and other crypto market participants. But there are a few potential downsides, one of which is that it thrust it into the regulatory spotlight. The U.S. Securities and Exchange Commission (SEC), which does not currently consider ether a security and therefore does not regulate it, says the proof-of-stake change makes it more of a security. This could require it to be registered and regulated by the SEC.

What is Merger?

The name comes from merging the original Ethereum Mainnet proof-of-work with a separate proof-of-stake blockchain called Beacon Chain, to create a single chain. “Fusion reduces Ethereum’s energy consumption by approximately 99.95%,” explains the Ethereum Foundation, the non-profit organization that supports network, currency, decentralized financial applications (DeFi), non-fungible tokens (NFT) and related technologies. “This eliminated the need for energy-intensive mining and instead allowed the network to be secured using staked ETH.”

Proof of work and mining are the processes used to validate new blocks on blockchains. “proof of work is the underlying algorithm that defines the difficulty and rules of the work that miners perform on proof-of-work blockchains,” explains the Ethereum Foundation. “Mining is ‘work’ itself. It is the act of adding valid blocks to the chain.”

Its big drawback is the large amount of electricity it uses. Shortly before The Merge, Ethereum miners were collectively using around 94 TWh (terawatt hours) of electricity per year, according to
Digiconomistwhich is roughly the same as Finland.

New proof of stake involves transactions being validated by a group of individuals and companies who have “staked” their own digital tokens for the security of the new chain. Each validator, also known as a staker, must stake their own ether to run validator software that creates and validates new blocks on the chain.

Staking serves a similar purpose to mining, but is different in several ways. Staking does not require large upfront expenditures on powerful hardware and power consumption like mining does; work can be done on personal computers, laptops or smartphones, which encourages more people to participate. Staking, unlike mining, requires the posting of assets as collateral – at least 32 ETH (equivalent to $41,913 at the time of writing) – to ensure that the validator has a “stake” in the made work. Validators earn new ether each time they add the next validated block to the blockchain.

There are over 300,000 Ethereum validators that can earn a staking return of 4% to 7% per year, depending on Forbes Advisor, the consumer credit platform. A minimum stake of 32 ETH is too high for many investors, but “individual advisors can also join staking pools, which are sets of Ethereum stakes that combine resources and share the rewards,” Forbes explains. Most cryptocurrency exchanges also provide staking services for investors who cannot afford the minimum stake.

The differences between proof-of-work and proof-of-stake mean that more people can participate in the network, making it more decentralized and secure, and it uses far less electricity. In early October, Digiconomist estimated that collectively, Ethereum validators were only using 0.01 TWh per year, roughly the same as Gibraltar. Bitcoin miners, on the other hand, who still use proof of work, were collectively consuming at the rate of 130 TWh per year by early October, about as much as Norway.

Ethereum had been planning the transition from proof-of-work to proof-of-stake for some time, with a key milestone being the December 2020 creation of the Beacon Chain to test and execute the proof-of-stake consensus logic. in parallel with Mainnet. When the logic proved solid and enduring, the two chains merged in September of this year. “No story has been lost in Fusion“, states the Foundation. When Mainnet merged with Beacon Chain, it also merged the entire transaction history of Ethereum. Users and holders of Ether and all other digital assets on Ethereum did not have had nothing to do with their funds or their portfolios.

Market reaction

The reaction of crypto investors, exchanges and other market participants to The Merge has been largely positive. Coinbase, the largest US cryptocurrency exchange, in a Blog repeated Ethereum’s claims that its move to proof-of-stake would make it “more secure, less energy-intensive, and better for implementing new scaling solutions.” Coinbase Senior Product Manager Armin Rezaiean-Asel also informed users that “rest assured, your assets will be safe and secure…and no action is required for the upgrade on your part.”

With the rise of DeFi and NFTs, the Ethereum network has suffered traffic bottlenecks and unpredictable spikes in transaction fees (gas). While proof-of-stake alone does not reduce transaction fees, it does allow Ethereum to continue to meet its scalability roadmap. “At Coinbase, we view this event as a major step towards the widespread adoption of the cryptoeconomy and we will support it in a variety of ways that align with our mission to increase economic freedom around the world,” Ms. Rezaiean-Asel.

Even so, Coinbase briefly halted new deposits and withdrawals of ETH and ERC-20 tokens during The Merge as “precautionary measureand to ensure that the transition is successfully reflected in his systems. Additionally, he warned users to beware of scams and not to send ETH to anyone with the intention of switching to ETH2 because there is no ETH2 token – ETH2 was simply the ticker that Coinbase overtook The Merge to represent staked ETH and is no longer used.

Despite such assurances, the price of ether has fallen since The Merge. On October 10, 1 ETH was worth $1,311, down 24% since September 10. This is a much larger drop than that suffered by bitcoin, which fell only 9% over the same period. Other large-cap currencies also performed better over the past month, such as Tether (down 0.03%), BNB (down 6.7%) and XRP (up 45%). However, to put that into perspective, Ether has been on a downward trend over the past year, with its value declining by 62% since October 2021.

Christopher Robbins, writing for CoinDesk, the crypto-asset information site, claims that The Merge brings many benefits, but there are some potential downsides. “There is still some debate about the consequences of new energy spending,” he writes, referring to the views of Omid Malekan, a professor at Columbia Business School, who questions the reality of the claimed energy savings. Another possible downside is that “proof-of-stake blockchains can be inherently centralizing.” Big investors can bet the biggest sums of money, “and then get more income than anyone else”.

Enter Regulators

Another problem is that he caught the attention of the authorities. Financial regulators around the world are tightening their rules on crypto-assets and taking enforcement action against market participants if necessary. The United States Securities and Exchange Commission (SEC) is no exception. Currently, the SEC does not consider ETH a security. But the merger could, in the eyes of the SEC, make it a security and bring it within the scope of the commission.

At the SEC Speaks conference on September 8, President Gary Gensler said he believed the “vast majority” of tokens in the crypto market are securities, describing them as “cryptographic security tokens” and therefore “covered by securities laws.” They are securities because people buy or sell them with the expectation of “profits from the efforts of others in a common enterprise”. But he also said a “small number” do not fall into this category, describing them as “insecure crypto tokens”.

Only a handful of crypto security tokens have registered under the existing regime, but Gensler has instructed his staff to work with issuers to get them “registered and regulated.”

Then a week later, on The Merge day, Mr. Gensler in testimony before the Senate Banking Committee suggested that a cryptocurrency going from proof-of-work to proof-of-stake could turn into a security and put it under the responsibility of the SEC because by staking coins “the investing public [is] anticipating profits based on the efforts of others”. Under proof-of-work, miners earned ETH by performing mathematical functions, under proof-of-stake, validators earn ETH based on the value of their stake which it’s more like an investment.

The future

What next? Ethereum co-founder Vitalik Buterin has a lot more in store for the network. At the annual Ethereum Community Conference in Paris in July, he outlined his plans, the first of which is “The Surge”, which will increase the scalability of stacks through sharding. Rollups are scaling systems that make a slow blockchain faster and cheaper. Sharding is the process of dividing a database horizontally to distribute the load, a common concept in computing, and is expected to happen next year.

Mr. Buterin talked about three more upgrades – The Purge, The Verge and The Splurge – which, combined with the first two, will make Ethereum more scalable, secure and sustainable while remaining decentralized. “At the end, Ethereum will be able to process 100,000 transactions per second,” he said.

Mind-boggling? It certainly is. But then, what would you expect from someone widely regarded as a genius with a fortune estimated at around 1 billion dollars?

The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.

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