Ethereum began running on two parallel blockchains in December 2020. One of the blockchains uses legacy systems to validate transactions and the other blockchains are tested and improved by developers using Proof of Stake. This merge combines two blockchains into one using a proof-of-stake system for verification.
Context
Ethereum, the world’s second most valuable digital currency by market capitalization, completed its long-awaited system upgrade on September 15th. Known as “The Merge” in the cryptocurrency community, it is expected to reduce energy costs and lay the groundwork for greater use of cryptography in mainstream applications.
Like Bitcoin and other lesser-known cryptocurrencies, Ethereum relied on network participants to solve complex mathematical problems to validate transactions. This is a process called proof of work. For their efforts, miners receive newly issued digital tokens. Ethereum’s new process will instead rely on what is known as Proof of Stake, eliminating the need for miners. Proof-of-work systems have recently been criticized for consuming huge amounts of power. In contrast, Proof of Stake systems use very little power.
How will this move make Ethereum more secure?
The Proof-of-Stake system makes decisions regarding updates to the Ethereum blockchain through voting by cryptocurrency holders. Voting power depends on how much ETH is staked. Large holders, for example, known as validators, invest 32 ETH and must fulfill certain obligations to maintain the integrity of the blockchain. Tokens that have been “staken” may be forfeited if the validator engages in fraudulent activities such as conducting invalid transactions. Promises of financial punishment for misbehaviour prevent the Ethereum blockchain from falling into a “51% attack”
How does this affect energy consumption and climate?
Ethereum’s move to proof-of-stake could reduce power consumption by as much as 99.95%. It’s no secret that proof-of-work cryptocurrency mining consumes a staggering amount of electricity. Bitcoin and Ethereum use more electricity than Sweden and Argentina. In bitcoin-friendly Texas, for example, cryptomining consumes about 3% of the region’s peak electricity demand and could account for a third of new electricity demand in Texas over the next decade. Since much of this electricity is generated from non-renewable sources such as wind and solar power, cryptocurrencies are responsible for large amounts of carbon dioxide and other emissions that contribute to climate change. In some states, cryptocurrency mining has reopened decommissioned power plants that burned fossil fuels to generate electricity, increasing the impact of mining on climate change.
Cryptocurrency mining also rapidly consumes and burns large amounts of computer hardware, creating approximately 38 kilotons of electronic waste (or “e-waste”) annually. E-waste is usually contaminated with toxic substances such as mercury, lead and arsenic, which can cause nervous system problems and cancer.
According to economists, Ethereum’s proof-of-stake system should significantly reduce e-waste emissions.
How does this transition affect investment?
This merger could help push cryptocurrencies into the mainstream not only because of the more energy-efficient proof-of-stake process, but also because of the financial incentives users have to stake their ETH to earn profits. A move to a proof-of-stake model should lower inflation, increase staking returns, and make it more attractive to institutional investors. Needham & Co. estimates that annual new ETH issuance will decrease from approximately 4.9 million per year before the merger to approximately 970,000 per year after the merger.
Currently, the validator’s return on his ETH staking is 4.1%, but consolidation could see this go up. This is a big deal for companies like crypto exchanges Coinbase and Kraken that allow investors to pool their ETH (currently a minimum of 32 ETH) for staking, as well as institutional and individual validators.
More on cryptocurrency profits here.
Why is it controversial?
Once merged, the network is essentially split in two, creating a PoS chain and a PoW chain. This is not the first time a major cryptocurrency has undergone a major fork. Bitcoin still uses PoW, but has forked many times to create spin-offs like Bitcoin Cash and Bitcoin Gold. Those who do not do this will adopt the new version. The decentralized nature of cryptocurrencies means there is no authority to enforce which chain is used, but consensus is needed between Ethereum-based projects and NFT marketplaces like OpenSea for example. The decision as to which are “real” NFTs can ultimately be left to the market.
Some crypto proponents, who value decentralization, argue that PoS moves away from crypto’s core principles by increasing centralization and control by large stakeholder groups. Another big resistance comes from people mining Ethereum right now. They invest a lot of money in the equipment needed to mine it and this way all computers used to generate income will be fully redundant in the PoS system.