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. Known as a “merge,” this event moves away from the Proof-of-Work (PoW) that Ethereum has used to process transactions since it went live in July 2015. In addition to the technical challenges of changing the base protocol to mid-stream, Ethereum also faces a challenge with economic incentives: PoW miners about to be fired could revolt and launch a controversial hard fork if “The Merge” occurs between March 10 and April 10 .and September 20, 2022.
The “merger” can go smoothly and usher in a new era of harmony and prosperity for Ethereum users – or it can cause a huge mess. Such a mess could involve anything from a massive technical outage of the new network to a series of point fires ignited by known and unknown stimuli flying in all directions. PoW miners may rebel and fork the threatened “Ethereum PoW” chain. Exchanges and DeFi/Token projects may have to decide which version of Ethereum to support. PoS and sharding may not be the panacea for Ethereum scaling. Even the Internal Revenue Service (IRS) may get involved, as the new ETH PoS asset technically qualifies as an “airdrop” and is a taxable event for holders.
Fascinating or scary?
This makes the “merge” a fascinating experiment for longtime Ethereum fans and those who have never owned a single ETH in their life. Even major Ethereum software development firm Consensys likened the “merge” to trying to switch a car’s engine from petrol to electric while the vehicle is cruising at full throttle and without the driver noticing a change.
The thought of doing this with a speeding car is technically intriguing… and quite terrifying.
It’s a daunting prospect for a network that carries so much of the value of the existing blockchain economy to even consider—let alone attempt—such a fundamental protocol change at this point. One has to wonder if this would be tolerated if Ethereum powered key government and corporate applications used in the physical world, and not just digital asset trading and DeFi.
What Proof-of-Stake is intended to do versus what actually happens
The move to PoS is intended (in theory) to make Ethereum scalable and reduce the overall energy consumption of the network. However, it is a significant change in economic incentives. Miners who have spent millions building and running PoW facilities need to do something different with their equipment. Their role is replaced by “validators”, ETH holders who stake (i.e. lock away) a portion of their holdings in exchange 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, only requires a large amount of digital assets. Some have jokingly referred to staking as “proof of oligarchy” as it encourages already big “whale” holders to become even bigger holders and rewards them with more money simply for having a lot of money to start with.
The above is what happens when all goes well. But in technology and finance, there are other, less recognized incentives at play.
A recent newsletter from FRNT Financial noted that Ethereum PoW miners have generated $11.56 billion in revenue since the beginning of 2022. That’s a lot more than BTC’s miners, who made $7.55 billion. These miners now face the prospect of finding a new (and presumably far less profitable) crypto coin to mine, or simply shutting down 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 brothers like Justin Sun and Chandler Guo.
The EthereumPOW (ETHW) movement is also known as “ETHW Core”. In this Twitter thread, the group says, “Migrating Web3’s key infrastructure to a Proof-of-Stake (PoS) solution will be a road to hell for the livelihood of the entire ecosystem.”
ETHW Core: An open letter to the Ethereum community [1/9]
ETHW has been controversial, to put it mildly, in recent weeks. The ETHW core feels compelled to clarify a few points:
1/n pic.twitter.com/lQHFCQatlS
— EthereumPoW (ETHW) Official #ETHW #ETHPoW (@EthereumPoW) August 29, 2022
Digital asset exchanges, which are generally more interested in trading profits than the functionality of a single blockchain, are also drooling at the thought of a new and popular asset. Most of them still support Ethereum Classic (ETC), the result of a previous controversial hard fork on Ethereum in 2016. Whether or not they have an interest in the Ethereum network itself, ETH traders and holders could benefit from the Prospect excited about free money should the network split up and give them duplicate assets with fiat money value.
The bottom line is that if the hypothetical Ethereum PoW network gets enough fanfare and support to be viable and profitable, it will become a thing. DeFi and token applications running on Ethereum might ignore any PoW fork and just focus on the main PoS network, but another “new Ethereum” might be a distraction in the market.
Institutional players and investors
The ConsenSys report “The Impact of The Merge on Institutions” explores how the move to PoS may impact major players in Ethereum’s DeFi/contract ecosystem. Despite being huge, it is still an economy based primarily on trading other digital assets and collectible tokens, coin staking, yield farming, and lending/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”, 13.3 million ETH (over $20.1 billion) were currently staked, or about 11% of the total ETH supply.
Ethereum is arguably the dominant blockchain when it comes to “total protocol revenue,” which the report says has reached $1.8 billion since March 2022, with a 90% share compared to other Layer 1 networks. This number includes the total amount of money flowing through the ecosystem and not just the market cap of the native token (where BTC still dominates).
In other words, there is a lot of money in Ethereum, although most of it is for buying and selling other digital assets.
ConsenSys sees the “merge” as having an overwhelmingly positive impact on the Ethereum economy, with improved security, lower energy consumption and scalability. However, it acknowledges issues with censorship and centralization that can come with PoS (e.g. Lido Finance currently controls nearly a third of all ETH staked).
Over the years, Ethereum has proven resilient to technical disruptions, protocol changes, and confusion over its staggering complexity as long as it sustains a large user base that can benefit from moving digital assets around the ecosystem. Whether this means resilience in the technological sense or in the sense of “too big to fail” 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 with keen interest what is happening.
Watch: The BSV Global Blockchain Convention presentation, Elas: Creating private, permissioned ledgers on the public blockchain
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