The blockchain underpinning the ether cryptocurrency has just been made more energy-efficient, secure, and scalable. Andrew Pimlott explains how it was done, the market and regulatory reaction, and likely future developments.
Ethereum, the blockchain that powers the ether (ETH) cryptocurrency, has upgraded its system in a move known as “The Merge”. On September 15th, it switched from a proof-of-work mechanism for verifying transactions to a proof-of-stake mechanism which, it says, will cut 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 some potential drawbacks, one of which is that it has placed it under the regulatory spotlight. The US Securities and Exchange Commission (SEC), which currently does not view ether as a security and therefore does not regulate it, says the change to proof-of-stake makes it more like a security. This could force it to be registered and regulated by the SEC.
What Is The Merge?
The name comes from the merger of the original proof-of-work Ethereum Mainnet with a separate proof-of-stake blockchain called Beacon Chain, to create just one chain. “The Merge reduced Ethereum's energy consumption by about 99.95%”, explains the Ethereum Foundation, the non-profit organization that supports the network, the currency, decentralized finance apps (DeFi), non-fungible tokens (NFTs), and related technologies. “It eliminated the need for energy-intensive mining and instead enabled the network to be secured using staked ETH.”
Proof-of-work and mining are the processes used for validating new blocks on blockchains. “Proof-of-work is the underlying algorithm that sets the difficulty and rules for the work miners do on proof-of-work blockchains,” is how the Ethereum Foundation explains it. “Mining is the ‘work’ itself. It's the act of adding valid blocks to the chain.”
Its big drawback is the large amounts of electricity it uses. Shortly before The Merge, Ethereum miners were collectively using about 94 TWh (terawatt hours) of electricity a year, according to Digiconomist, which is about the same as Finland.
The new proof-of-stake method 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, has to stake their own ether to run the validation 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 up front expenditure in powerful hardware and energy use like mining does; the work can be done on home computers, laptops, or smartphones, encouraging more people to take part. Staking, unlike mining, requires depositing assets as collateral – at least 32 ETH (equivalent to 41,913 USD at the time of writing) – to ensure the validator has a “stake” in the work done. Validators earn new ether every time they add the next validated block to the blockchain.
There are more than 300,000 Ethereum validators who can earn a staking yield of 4% to 7% a year, according to Forbes Advisor, the consumer finance platform. A minimum stake of 32 ETH is too high for many investors, but “individual advisers can also join staking pools, which are collections of Ethereum stakes who combine resources and split the rewards”, says Forbes. 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 more secure, and it uses far less electricity. In early October, Digiconomist estimated that collectively Ethereum validators were using only 0.01 TWh a year, about 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 a year in early October, about as much as Norway.
Ethereum had been planning the transition from proof-of-work to proof-of-stake for some time, a key stage being the creation in December 2020 of the Beacon Chain to test the proof-of-stake consensus logic and run it in parallel with Mainnet. When the logic proved to be sound and sustainable, the two chains merged in September this year. “No history was lost in The Merge,” says the Foundation. As Mainnet merged with the Beacon Chain, it also merged the entire transactional history of Ethereum. Users and holders of ether and all other digital assets on Ethereum did not need to do anything with their funds or wallets.
The reaction of crypto investors, exchanges, and other market participants to The Merge has been largely positive. Coinbase, the largest US cryptocurrency exchange platform, 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”. Armin Rezaiean-Asel, Coinbase’s Senior Product Manager, also informed users that “rest assured, your assets will be safe and secure… and no action is required to upgrade on your part”.
With the rise of DeFi and NFTs, the Ethereum network had endured traffic bottlenecks and unpredictable spikes in transaction (gas) fees. Although proof-of-stake on its own does not lower transaction fees, it does set Ethereum up to continue delivering on its scalability roadmap. “At Coinbase we view this event as a major step toward scaling adoption of the cryptoeconomy and will support it in a variety of ways that align with our mission to increase economic freedom in the world,” wrote Mr. Rezaiean-Asel.
Even so, Coinbase briefly halted new ETH and ERC-20 token deposits and withdrawals during The Merge as a “precautionary measure” and to ensure that the transition was successfully reflected in its systems. Moreover, it warned users to be wary of scams and not to send ETH to anyone in an attempt to upgrade to ETH2 as there is no ETH2 token – ETH2 was simply the ticker that Coinbase set ahead of The Merge to represent staked ETH and is no longer used.
Despite assurances like these, the price of ether has fallen since The Merge. On October 10th, 1 ETH was worth 1,311 USD, a fall of 24% since September 10th. This is a far bigger fall than that experienced by bitcoin which only fell 9% over the same period. Other currencies with large market capitalization have also fared better in the past month, such as Tether (minus 0.03%), BNB (minus 6.7%), and XRP (plus 45%). However, to put this in perspective, ether has been on a downward trend over the past year, having declined in value by 62% since October 2021.
Christopher Robbins, writing for CoinDesk, the cryptoassets news site, says The Merge brings many benefits but there are some potential drawbacks. “There’s still some degree of debate over the consequences of the new energy expenditure,” he writes, referring to the views of Omid Malekan, a Columbia Business School professor, who casts doubt on whether the claimed energy savings claimed will actually be achieved. Another possible downside is that “proof-of-stake blockchains can be inherently centralizing”. Large investors can stake the largest sums of money, “and then get more income than anyone else”.
Enter the Regulators
Another problem is that it has attracted the attention of the authorities. Financial regulators around the world are tightening up their rules on cryptoassets and taking enforcement action against market participants where necessary. The US Securities and Exchange Commission (SEC) is no exception. Currently, the SEC does not regard ETH as a security. But the Merge could, in the eyes of the SEC, turn it into a security, and bring it within the commission’s ambit.
At the SEC Speaks conference on September 8th, Chairman Gary Gensler said he believed that the “vast majority” of tokens in the crypto market are securities, describing them as “crypto security tokens” and therefore “covered under the securities laws”. They are securities because people buy or sell them in the expectation of “profits derived from the efforts of others in a common enterprise”. But he also said that a “small number” do not fall into that category, describing them as “crypto non-security tokens”.
Only a handful of crypto security tokens have registered under the existing regime, but Mr. Gensler has asked his staff to work with the issuers to get them “registered and regulated”.
Then a week later on the day of The Merge, Mr. Gensler in a testimony before the Senate Banking Committee suggested that a cryptocurrency transitioning from proof-of-work to proof-of-stake could turn itself into a security and place it under the SEC’s purview 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 makes it look more like an investment.
So 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 scalability for rollups through sharding. Rollups are scaling systems which make a slow blockchain faster and cheaper. Sharding is the process of splitting a database horizontally to spread the load, a common concept in computer science, and is due to take place next year.
Mr. Buterin spoke about three further 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. “By 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 an estimated fortune of around $1bn?
Andrew Pimlott is Senior Managing Director, Financial Services, Data and Technology, EMEIA, Ankura Consulting.
© Copyright 2022. The views expressed herein are those of the author(s) and not necessarily the views of Ankura Consulting Group, LLC., its management, its subsidiaries, its affiliates, or its other professionals. Ankura is not a law firm and cannot provide legal advice.