Ethereum’s Merge already causing more problems than it’s solving

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Ethereum’s long-awaited transition to a proof-of-stake (PoS) blockchain has a new launch date but the shift may actually create more problems than it solves.

Last week, Ethereum poster boy Vitalik Buterin announced that the ‘Merge’—aka the final step in the shift from a proof-of-work (PoW) blockchain consensus mechanism to PoS—will now likely take place around September 15. The resulting blockchain—formerly referred to as Ethereum 2.0, now sticking with plain old Ethereum—allegedly gets Buterin one step closer to finally enabling greater scalability and eliminating the network congestion that has plagued the chain from Day 1 and led to impossibly high transaction fees. Or does it?

The Ethereum Foundation put out a message this week stating: “Gas fees are a product of network demand relative to the network’s capacity. The Merge deprecates the use of proof-of-work, transitioning to proof-of-stake for consensus, but does not significantly change any parameters that directly influence network capacity or throughput.”

This is far from the first ‘countdown to launch’ that this upgrade has announced over its six-year gestation, so not all are convinced the world will wake up on September 16 with a shiny new scalable Ethereum. The one thing that is certain once the merge is complete though, Ethereum will clearly be considered a security not a commodity. There are also those who aren’t yet convinced that the transition will be done without significant unforeseen hitches.

Count the Coinbase (NASDAQ: COIN) digital asset exchange in that latter bunch, as this week it informed users of its plan to “briefly pause” deposits and withdrawals of both ‘new Ethereum’ and the host of ERC-20 tokens linked with the Ethereum chain. This pause is “to ensure that the transition has been successfully reflected by our systems.”

‘Crypto’ speculators briefly pushed the ETH token’s value up over $2,000 earlier this month, although the market has given back some of those gains over the past week. Regardless, it’s still above the sub-$900 level it sank to in mid-June, so clearly speculators are banking that a successful Merge will result in a healthy bull run.

But the Merge is far from universally supported, in part because the new PoS model renders competitive blockchain miners redundant. These miners aren’t taking this lying down, with a growing number of them voicing support for a forked version of ETH they’re calling ETHW, which will continue to be based on the old PoW model.

Several prominent exchanges have indicated their support for ETHW, including BitMEX, Bitrue, Huobi and Poloniex. Binance is reportedly on the fence but has yet to confirm its plans either way. Other ‘crypto’ entities, including stablecoin providers Circle and Tether, have emphatically ruled out any interest in propping up ETHW.

There’s already the original Ethereum blockchain, aka Ethereum Classic (ETC), that resulted from Vitalik Buterin’s infamous decision to roll back all transactions that followed the hack of The DAO. While technically the original chain, the ETC token has a much smaller market cap than ETH. Regardless, Buterin and fellow travelers such as Digital Currency Group CEO Barry Silbert have urged miners to transfer their affections to ETC rather than confuse the market further via the launch of ETHW.

All things to all scammers

Intended to be a ‘world computer’ (in reality, more of a ‘world abacus’), Ethereum has been the go-to chain for scammers to birth tokens of utterly dubious quality via initial coin offerings. Ethereum is also home to the bulk of poorly coded decentralized finance (DeFi) offerings that have fallen prey to hacks or rug-pulls, as well as innumerable function-free non-fungible token (NFT) art projects that promised riches but delivered only disappointment.

In short, Buterin and his group of centralized co-developers bear a lot of the blame for the current ‘crypto winter.’ But the extensive pre-mine of ETH that lavishly rewarded Ethereum’s developers and early investors is also largely responsible for the U.S. Securities and Exchange Commission (SEC) taking the view that most digital assets are unregistered securities. This has dramatically increased the likelihood that exchanges such as Coinbase will find themselves charged with violating securities laws.

Ethereum’s switch to a PoS model will only reinforce the idea that ETH is a security, as the ‘validators’ who must stake 32 ETH (currently worth over U.S.$58,000) to participate in the new consensus mechanism seem to fit the ‘investment of money in a common enterprise with the expectation of profit’ elements of the Howey Test for identifying a security.

The Howey Test can be a little unclear on whether said profit needs to be ‘derived from the efforts of others,’ although the concentration of power and influence within the Ethereum Foundation—not to mention the relatively small number of sufficiently well-heeled validators who can afford to stake at least 32 ETH—strongly suggests the new ETH will meet this requirement as well.

Tornado warning

Despite the recognition that Ethereum is sitting on a regulatory time bomb, Buterin hasn’t been shy in calling out Ethereum validators who’ve indicated that they’ll comply with sanctions imposed against the Tornado Cash crypto mixing service by the U.S. Treasury Department’s Office of Foreign Assets Control (OFAC).

The OFAC blacklisted Ethereum addresses linked to Tornado Cash based on its contention that the mixer was laundering ill-gotten digital assets derived from cybercrimes, “including those committed against victims in the United States.” While the OFAC could be targeting only those addresses that had significant interactions with Tornado Cash, the fear is that all Ethereum addresses that ever made use of the service could find themselves on the Specially Designated Nationals list of sanction-flaunting individuals/entities.

Malicious actors and/or reckless pranksters have seized on this ambiguity by initiating unwanted transfers of 0.1 ETH from blacklisted Tornado Cash addresses to a variety of big crypto names, apparently in the hopes that major Ethereum validators would refuse further interactions with these recipients.

Developer Eric Wall organized a Twitter poll to determine whether or not the ‘Ethereum community’ should retaliate against staked validators who comply with the OFAC sanctions. The two choices were to “Consider the censorship an attack on Ethereum and burn their stake via social consensus” or “tolerate the censorship.” Over three-fifths of respondents (including Buterin) agreed with burning validators’ stakes.

Problem is, a mere five entities—including Coinbase—control a clear majority of the staked ETH that will be used to validate transactions on the new Ethereum, which makes it hard to sell the false narrative that the network is as decentralized as Foundation members such as Buterin like to claim.

Coinbase CEO Brian Armstrong attempted to douse these embers before it became a wildfire of crypto bro anger by tweeting that Wall’s A/B choice was “a hypothetical we hopefully won’t actually face. But if we did we’d go with B i think. Got to focus on the bigger picture. There may be some better option (C) or a legal challenge as well that could help reach a better outcome.”

But with Coinbase recently declaring that staking will be a big part of the solution to the $1.1 billion in red ink on its Q2 earnings report, don’t expect it to risk its financial future on a principled anti-censorship stand against the U.S. federal government, particularly given the problems it’s facing with the SEC.

To sum up, Ethereum’s Merge increasingly appears to be steering its users into a regulatory dead end. Hey, do you think the ‘s’ in PoS actually stands for snafu?

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