On September 15, 2022, Ethereum completed The Merge.
For many crypto enthusiasts, this was one of the most hotly anticipated events of the year. Some hailed it as a revolutionary step forward for the industry. Eli Ben-Sasson, co-founder of the blockchain software company StarkWare, tweeted that it was "like watching [the] Webb Telescope unfold." Others were less enthusiastic, warning that it makes the network less decentralized.
Let's take a closer look at the implications of The Merge and why it generated both excitement and controversy.
What is the Ethereum Merge?
In simple terms, The Merge was a lot like a software update for the second biggest cryptocurrency, similar to how your smartphone or computer might upgrade to a new operating system. However, this was no ordinary update. The Ethereum team has been planning The Merge since 2017, which means this project was nearly half a decade in the making.
The Merge transitioned the Ethereum network from proof of work (PoW) to proof of stake (PoS), which has major implications for some of the most controversial topics in crypto, including energy usage, decentralization, legal classifications, economic factors, and more.
What is proof of stake and how is it different from proof of work?
Remember that cryptocurrencies keep track of who has how many coins on a ledger (think of the ledger like one big spreadsheet). Because transactions are continuously happening, the ledger needs to be updated regularly. And because the goal is to decentralize the ledger so it can't be controlled by a single entity, each update is carried out by someone different. These updaters are paid by the system for their work in the cryptocurrency they are updating.
But who gets to update the ledger?
Proof of work decides this through competition. For each collection of transactions, it assigns a complex puzzle that can only be solved with brute computing power. One way to think of this puzzle is like a random locker combination with one million numbers.
Whoever guesses the combination correctly first wins the right to update the ledger, a challenge that requires several powerful computers guessing all the possible combinations as quickly as possible. Those who take part in this competition are called miners.
Up until September 15, 2022, Ethereum operated on proof of work. Bitcoin, the world's largest cryptocurrency by market cap, continues to use proof of work.
With proof of stake, however, the person who gets to update the ledger isn't decided by competition. Instead, they're chosen based on chance.
Here's how it works: Under proof of stake, ethereum holders can choose to "stake" their coins. Think of staking like depositing money in a special bank account. Coins that are staked are locked in this account and can't be used for anything else unless you choose to withdraw them.
For each collection of transactions, one person with staked ethereum is randomly chosen to update the ledger. However, note that you must have at least 32 ETH (ethereum tokens) staked to qualify. No miners are required for proof of stake.
Implications of Ethereum's shift to proof of stake
Let's explore some arguments for and against proof of stake.
Arguments in favor of proof of stake
Significantly reduced energy usage
Ethereum was once one of the least energy-efficient cryptocurrencies alongside bitcoin. But without the need for an army of high-powered computers to update the ledger, the Ethereum network now requires far less energy to run.
According to a report from the CCRI (Crypto Carbon Ratings Institute), The Merge reduced both its energy usage and carbon footprint by approximately 99.99% (note that the report was commissioned by ConsenSys, a software company that develops products on the Ethereum blockchain).
Digiconomist, a crypto-skeptic website "dedicated to exposing the unintended consequences of digital trends," seemed to agree with the CCRI report. Before The Merge, their Ethereum Energy Consumption Index estimated a yearly energy consumption as high as 93.98 terawatts. After The Merge, that estimate fell to just 0.01 terawatts (as of September 18, 2022).
May promote deflation
Before The Merge, Ethereum's proof of work model meant it had to issue new coins to miners. Unlike bitcoin's 21 million limit, Ethereum does not currently have a hard cap on its supply, which stokes fears of inflation.
The transition to proof of stake eliminates the need to issue new coins to miners, which advocates argue helps prevent inflation. While new coins are still being created to pay stakers who are chosen to update the ledger, they're issued at a lower rate.
The Ethereum network also has a process for burning, i.e., removing coins from supply. After The Merge, the rate at which it burns coins is expected to be higher than the rate at which it issues new coins, which may allow it to eventually become deflationary. Staking itself will also remove coins from circulation. Those who believe scarcity will increase the value of their investments see deflation as a good thing.
However, some skeptics aren't sure if the burn rate will be high enough to achieve this effect, at least in the short term. Coins are only burned when transactions occur, and due to 2022's bear market, skeptics don't think there will be enough transactions to encourage deflation in the current economy.
Allows stakers to earn interest
Another way staking is similar to keeping money in a bank account is that it can generate interest for its holders.
Note that while this may help investors accumulate more ethereum, it has risks as well. For example, staking often involves a lock-up period, where you can't sell or withdraw your coins. If the value of ethereum falls during the lock-up period, your investment may be worth less by the end of that period, even with the interest earned.
Arguments against proof of stake
May make Ethereum less decentralized
One of the most common criticisms of the proof of stake transition is that it puts too much control in the hands of a few entities. For example, in order to be chosen to update the ledger, you must have at least 32 ETH staked, which is an amount many casual investors may not be interested in committing. This may give the advantage to a small group of big players, which could make the system more centralized.
Critics are also worried about 51% attacks, where an individual or entity controls the majority of the staking supply. This could increase the risk of manipulation or censorship by large entities or governments.
Advocates argue that these same concerns are present with proof of work, where someone can manipulate the ledger by accumulating the majority of the available computing power. They also argue that it's easier to recover from a 51% attack under proof of stake because it allows users to vote to move to a new version of the blockchain.
Finally, proof of stake also allows Ethereum to penalize bad actors by confiscating their stakes, which advocates argue reduces the incentive for attacks.
May open the door to new attacks
Ethereum.org, the official site of the Ethereum Foundation, notes that proof of stake is "more complex to implement than proof of work," and is also "younger and less battle-tested compared to proof of work."
Investors should be aware that there could be unforeseen challenges ahead, i.e., unexpected cyberattacks or takeover attempts. However, unlike some cryptocurrencies, the Ethereum network has an active development team, which may make it easier to solve new problems.
May trigger classification as a security
While no official statements by relevant government agencies have been made yet, some think the shift to proof of stake means ethereum could be reclassified as a security rather than a commodity. In August 2022, the Digital Commodities Consumer Protection Act named bitcoin and ethereum as commodities. But shortly after The Merge in September, SEC chairman Gary Gensler said proof of stake cryptocurrencies could qualify as securities.
If ethereum is indeed classified as a security rather than a commodity, it could fall under stricter regulations from the SEC.
What is the Shanghai Upgrade (also called "Shapella")?
Although The Merge was initiated in 2022, it won't be 100% complete until it finishes a series of technical updates.
The first of these updates, the Shanghai Upgrade (also referred to as "Shapella"), was completed on April 12th, 2023. The update's purpose was to initiate a series of software updates. Perhaps most significantly, it allowed users who staked ethereum to withdraw their coins. Users who staked ethereum in 2022 were previously unsure when they would be able to withdraw.
What to consider if you are investing in post-Merge ethereum
Make sure to understand The Merge and its potential implications before adding ethereum to your portfolio.
And be cautious when considering staking. While the ability to earn interest may be attractive, remember that there are risks, including uncertainty around when you'll be able to withdraw your coins. You may want to consider only staking an amount you are comfortable with losing.
Finally, keep in mind that The Merge was just the latest change to the Ethereum network. Be aware that more updates are in the works, and may be initiated in the coming months.