Fintech

Why crypto is thrilled — and nervous — about the Ethereum Merge

The second-largest blockchain is going all in on proof of stake in September. Crypto experts see opportunities and dangers ahead.

A passenger jumps from a train compartment to another at a railway station during a nationwide strike in Kolkata on September 20, 2012. Shopkeepers, traders and labourers blocked railway lines and closed markets across India September 20 in a nationwide day of protest against reforms allowing in foreign supermarkets such as Walmart. AFP PHOTO/Dibyangshu SARKAR (Photo credit should read DIBYANGSHU SARKAR/AFP/GettyImages)

Sara Xi, chief product officer of Prime Trust, likens the Merge to moving cargo from one train to another while the two are moving.

Photo: Dibyangshu Sarkar/AFP/Getty Images

In crypto, it’s simply known as “the Merge,” the key milestone when a major industry player shifts to a new system of verifying transactions.

On Sept. 19, Ethereum is scheduled to make that much-anticipated transition, leaping from its original proof-of-work system to a newer layer based on a proof-of-stake mechanism.

The switch will purportedly transform Ethereum into a more scalable, secure and eco-friendly network. But it involves a complex process that experts say is fraught with risks, potentially causing serious disruptions in crypto’s second-biggest ecosystem.

Sara Xi, chief product officer of Prime Trust, likens the Merge to moving cargo from one train to another while the two are moving.

“Once the Merge takes place, it runs just like a normal train and then you can take the cargo out,” she said. “People also use [the analogy], ‘Oh, you have two planes midflight and you're swapping out engines.’ That really scares people.”

There’s fear around the Merge, but also excitement.

The change will likely enhance Ethereum’s cred as a more environmentally responsible ecosystem than, say, bitcoin. By moving away from proof of work, which bitcoin and several other currencies are sticking with, the blockchain is abandoning a system of “mining” that’s long been denounced for excessive energy use. The Ethereum Foundation says the Merge will reduce the network’s energy consumption by 99.95%.

“They're reducing energy by getting rid of the miners,” Mike Fasanello, chief compliance officer of LVL, told Protocol. “That's a huge answer to environmentalist calls.” Ethereum’s plan to drop crypto mining, he said, was “one of the big reasons people flocked” to it versus bitcoin. “Now it's going to be even more so.”

The Merge is also expected to bolster the value and market position of ether, Ethereum’s native cryptocurrency, Fasanello added.

Even after the crypto market’s crash, ether currently has a market cap around $200 billion, making it the second most valuable cryptocurrency after bitcoin, which is worth roughly $410 billion. Ethereum, which supports other cryptocurrencies as well, plays a critical role in crypto as the industry’s dominant blockchain for smart contracts.

“If the Merge takes place, then it's really solidifying its position as the largest smart contract developer network,” Xi said.

Chainalysis economist Ethan McMahon said the change is also expected to make the Ethereum ecosystem more attractive to traditional financial institutions “who may have been standing on the sidelines for a while.”

But there are worries about how the Merge will play out.

One big concern is scams. The Ethereum network and some in the broader crypto community have been using the shorthand “ETH2” to refer to the proof-of-stake layer. The Ethereum Foundation has acknowledged that this could lead to confusion during the Merge and warned against “scams trying to take advantage of users during this transition” by making them believe that they need to take steps to upgrade to ETH2 or swap their current tokens for new ones.

“There is no ‘ETH2’ token, and there is nothing more you need to do for your funds to remain safe,” the foundation said.

Another key question: What happens to Ethereum’s miners?

The proof-of-work Ethereum network, known as Mainnet, has relied on miners to validate blockchain transactions. Ethereum’s proof-of-stake layer, known as the Beacon Chain, will rely on builders (who bundle transactions together) and validators, whose ability to select and validate transaction blocks depends on how much cryptocurrency they own.

Andy Long, CEO of White Rock Management, said that for miners, the Merge means “the end of the super-normal returns they've enjoyed lately.” McMahon of Chainalysis agreed, saying Ethereum miners face a “grim” future.

That has led to some speculation that the Ethereum miners would opt to keep going on their own, leading to the creation of a fork, similar to one that created Ethereum Classic in 2016.

Omid Malekan, who teaches blockchain and cryptocurrencies at Columbia Business School, pointed to the risk of “having two competing chains in the short term,” which could lead to confusion. “Anyone who issues a token that has some kind of off-chain reserve like a stablecoin is going to have to decide which version of their token is the one that's redeemable,” he told Protocol.

Circle, the issuer of USDC, which uses Ethereum, addressed the fork issue in a blog post about the Merge. “While we don’t speculate on the possibility of forks post Ethereum Mainnet merge, USDC as an Ethereum asset can only exist as a single valid ‘version,’ and as stated previously, our sole plan is to fully support the upgraded Ethereum [point-of-stake] chain.”

Experts said technology glitches could prevent a smooth transition to the new system: for example, if validators or other nodes fail to update their software. That could spook the market.

“If the Ethereum Merge fails or has substantial setbacks, that's going to trigger a devaluation of the currency,” Fasanello said. “It's gonna really test the stomachs of investors and speculators,” he added, and could trigger a new crypto winter.

Xi said a fumbled or failed Merge would hurt Ethereum’s standing as the dominant smart contract network. “It gives opportunities to all the alternative smart contract chains,” she said, citing Solana and Avalanche as examples.

“It is their moment to shine if Ethereum doesn't complete the Merge,” she said. “There are much faster and cheaper chains. If Ethereum fails, it will in the short term push up the prices for all the alternatives out there.”

But Xi suggested the worst-case scenarios may not play out. “I try not to worry about things I have no control over,” she said. “I have a moderate level of confidence in the technology.”

There are still many reasons to be optimistic, she said, that “the trains don't crash and we actually move everything to the new train.”

Update: The attribution on statements made by the Ethereum Foundation cited in this article was clarified.

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