The Ethereum network, which carries up to 70% of the world’s decentralized finance (DeFi) traffic, is just days away from transitioning to a Proof-of-Stake (PoS) model. This event is known as the “Merge” and moves away from Proof-of-Work (PoW), which Ethereum has used to process transactions since it went live in July 2015. On top of the technical challenges of altering the base protocol mid-stream, Ethereum also faces a challenge with economic incentives: PoW miners about to become redundant may revolt and launch a contentious hard fork when “The Merge” is triggered between September 10 and 20, 2022.
The “Merge” may happen smoothly, ushering in a new era of harmony and prosperity for Ethereum users—or it may create a huge mess. Such a mess could involve anything from massive technical failure on the new network to a series of spot fires lit by known and unknown incentives flying in all directions. PoW miners may rebel and fork the threatened “Ethereum PoW” chain. Exchanges and DeFi/token projects may have to choose which version of Ethereum to support. PoS and “sharding” may not be the magic bullet for scaling Ethereum. Even the Internal Revenue Service (IRS) may get involved since the new ETH PoS asset technically qualifies as an “airdrop” and is a taxable event for holders.
Fascinating or frightening?
This makes the “Merge” a fascinating experiment for long-term Ethereum fans and those who’ve never held a single ETH in their lives. Even major Ethereum software development firm Consensys likened the “Merge” to attempting to switch a car’s engine from gas to electric while the vehicle moves at full throttle and without the driver noticing any change.
The thought of doing that with a speeding car is technically intriguing… and quite terrifying.
It’s a frightening prospect for a network, which carries so much of the existing blockchain economy’s value, to even contemplate such a fundamental protocol change at this point—let alone attempt it. One has to wonder if this would be tolerated if Ethereum was driving major government and enterprise applications used in the physical world rather than just digital asset trading and DeFi.
What Proof-of-Stake is meant to do vs what actually happens
The shift to PoS is designed (in theory) to make Ethereum scalable and reduce the network’s overall energy consumption. However, it’s a significant alteration to economic incentives. Miners who’ve spent millions building and operating PoW facilities will need to find something else to do with their equipment. Their role will be replaced by “validators,” ETH holders who stake (i.e. lock away) a proportion of their holdings in return for rewards. There will also be systematic “burns,” or reductions in the overall ETH supply, to make the ETH asset more valuable.
PoW uses money, expertise, reputation, and time invested in physical facilities to secure a blockchain network. PoS, on the other hand, requires only a large amount of digital assets. Some have jokingly referred to staking as “proof of oligarchy” since it incentivizes already-large “whale” holders to become even larger holders, rewarding them with more money simply for having a lot of money to begin with.
The above is what happens when everything goes well. But in technology and finance, other less-acknowledged incentives are in play.
A recent newsletter from FRNT Financial noted that Ethereum’s PoW miners had earned $11.56 billion in revenue since the start of 2022. This is a lot more than BTC’s miners, who made $7.55 billion. These miners are now faced with the prospect of finding a new (and presumably far less profitable) cryptocoin to mine or simply switch off their machines altogether. This alone creates an incentive to fork the chain and create “Ethereum PoW,” which is already a movement with a large following that includes crypto bros like Justin Sun and Chandler Guo.
The EthereumPOW (ETHW) movement is also known as the “ETHW Core.” In this Twitter thread, the group says, “Pivoting the most important infrastructure of Web3 to a proof-of-stake (PoS) solution is going to be a way to hell for the livelihood of the entire ecosystem.”
ETHW Core: An open letter to the Ethereum community [1/9]
The ETHW has been controversial, to say the least, in the past few weeks. The ETHW Core feels compelled to clarify a few points:
— EthereumPoW (ETHW) Official (@EthereumPoW) August 29, 2022
Digital asset exchanges, generally more interested in trading profits than the functionality of any one blockchain, are also salivating at the thought of a new and popular asset. Most of them still support Ethereum Classic (ETC), the result of a previous contentious hard-fork on Ethereum back in 2016. Whether they have any interest in the Ethereum network itself or not, traders and holders of ETH may be excited at the prospect of free money should the network split and award them duplicate assets with fiat-money value.
The bottom line is that if the hypothetical Ethereum PoW network gets enough buzz and support to be viable and profitable, it will become a thing. DeFi and token applications running on Ethereum could ignore any PoW fork and focus only on the main PoS network, but another “new Ethereum” could be a distraction in the market.
Institutional stakers and investors
ConsenSys’ “The Impact of The Merge on Institutions” report examines how switching to PoS may affect large players in Ethereum’s DeFi/contract ecosystem. Though massive, it’s still an economy based mainly on trading other digital assets and collectible tokens, coin-staking, yield-farming, and borrowing/lending. Post-Merge will include a larger share of “institutional staking services,” working to generate rewards for ETH holders based on the size of their ETH holdings. Even before the “Merge,” there were 13.3 million ETH (over U.S.$20.1 billion) currently staked or about 11% of the entire ETH supply.
Ethereum is arguably the dominant blockchain when counting “total protocol revenue,” which the report says reached $1.8 billion since March 2022 with a 90% share relative to other Layer 1 networks. That figure includes the total amount of money flowing through the ecosystem rather than just the native token’s market cap (where BTC still dominates).
In other words, there’s a lot of money in Ethereum, even if most of it is there to buy and sell other digital assets.
ConsenSys sees the “Merge” as having a mostly positive impact on Ethereum’s economy, with improved security, lower energy consumption, and scalability. However, it acknowledges problems with censorship and centralization that may come with PoS (e.g., Lido Finance currently controls nearly a third of all staked ETH).
Over the years, Ethereum has proven to be resilient to technical glitches, protocol changes, and confusion over its eye-watering complexity, as long as it maintains a large user base that can profit from moving digital assets around the ecosystem. Whether that means resilience in the technological sense or in the “too big to fail” sense is still unknown. Neither Ethereum nor any other network has attempted a shift as large as the “Merge” before. Technologists, financiers, regulators, lawyers, and average users will all be watching what happens with great interest.
Watch: The BSV Global Blockchain Convention presentation, Elas: Creating private, permissioned ledgers on the public blockchain
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