In September 2022, Ethereum will move from proof-of-work to proof-of-stake. This is the biggest change since the inception of Ethereum, and the largest change in crypto history.
In this week’s deep-dive, we’re going to look at what the change is, it’s objectives, and most importantly, why some folks are trying to resist the change.
What is The Merge?
The Merge refers to Ethereum’s move from proof-of-work (PoW) to proof-of-stake (PoS).
A blockchain needs some mechanism to prove that transactions are legitimate. Blockchains are decentralised. Nobody controls them. As a result, you need some way to agree that something actually happened. PoW and PoS are the two most popular methods to achieve this.
With PoW, all nodes compete to be the first to verify a transaction. It’s like a math puzzle and the winner gets a reward. The better your hardware, the higher the probability of you being the first to complete verification and win the prize. As a consequence, miners aim for the best hardware.
The hardware is expensive and consumes a lot of energy. This energy consumption and its environmental impact is difficult to ignore. It is often cited by crypto skeptics.
An important point to note here is that the reward for miners is newly issued Ethereum. It increases the supply of Ethereum and makes it less valuable, everything else constant. It’s comparable to inflation in an economy.
With PoS, a few nodes (called validators) “stake” some Ethereum to verify the transaction. When they verify the transaction they earn a fee. But couldn’t the validators coordinate and agree on a transaction that didn’t take place? For example, they could a verify a transaction (that never really took place) to send $1 billion Ether to their address. This is called a sybil attack, it’s very similar to collusion.
PoS prevents sybil attacks by ensuring that the cost of the attack is greater than the prize. If validators verify a transaction incorrectly, their stake is slashed. To take control of the entire network, enough nodes would need to collude. The risk of doing so and having their stake slashed is too high.
Objectives of the Merge
There are 3 objectives for this change:
It reduces the consumption of energy. This is because, unlike PoW, expensive hardware does not improve your return as a validator. It is estimated that the move to PoS reduces energy consumption by 95%.
It’s more secure. The hardware requirements for PoS vs. PoW. This means more people can participate in securing the network. The greater the number of participants, the harder it is to collude and take over the network.
It’s less inflationary. The rate at which Ethereum is issued (comparable to inflation) is estimated to fall from 4.62% to 0.49%. This happens because the reward for validators with PoS is lower than it is for miners with PoW.
Why is everyone talking about a fork?
Over the last few weeks, there’s been talk of an Ethereum fork. A subset of users wish to stay on the PoW consensus method.
Ethereum is open-source and decentralised. This means that anyone can create a fork at any point. This also not the first time — Ethereum was forked in 2016. In July 2016, Ethereum was hacked. The community decided to fork the blockchain and recover the funds that the hacker stole.
A part of the community believed that the fork was against the principles of Ethereum. They condemned the hack of course. But also felt that a truly decentralised cryptocurrency should remain, well, decentralised. These believers decided to stay on the original version of Ethereum — called Ethereum Classic (ETC).
Anyway, back to the latest fork. There’s a set of Ethereum users who want to remain on the PoW chain. There are three reasons for this:
Chance of failure. If something does go wrong, they claim that the PoW will provide insurance.
Decentralisation. They claim that it’s more decentralised than PoS. This debate has really heated up after the US banned Tornado Cash. There’s concern that US authorities might ask validators to stop validating “sanctioned” transactions. A sanctioned transaction is a transaction involving any contract that has interacted with Tornado Cash (or addresses that might be banned in the future).
Keep making money. The real reason though is that miners want to continue making money. They invested in expensive equipment. Using the equipment for proof-of-work is a much better return on investment, because your hardware has real implications on the reward you may receive. They want to squeeze as much as they can out of the asset. If there’s no cost to trying, what’s the harm in doing so? My point:
A proof-of-work fork is inevitable.
What does this mean for your assets?
If you own Ethereum and are happy with the changes proposed above, you’re fine. There’s nothing you need to do. The change and move will be seamless, unless there’s a technical glitch of some sort.
It’s a little more complicated if you want to remain on the PoW version of Ethereum.
First, you’ll need to ensure that your protocol intends to support PoW post the Merge. For example, Aave, the leading DeFi lending protocol, has a proposal out to universally support the PoS version of Ethereum. It’s like to pass.
Second, assuming your protocol intends to support the PoW, you’ll need to form a view of whether enough users will want to stay and transact on it. The PoW fork is very similar to new blockchain. It carries the “state” of Ethereum at the time of the fork. For example, if you own 20 Ether before the merge, you’ll own 20 Ether post the merge on the PoS and PoW versions.
The real question is: how much will your ETH be worth on the PoW version?
Let’s use a stable coin like USDC as an example. The reason people trust USDC is because they know that 1 unit of USDC is redeemable for $1. Now, USDC will exist on the PoW and the PoS version. USDC will always be redeemable on the PoS version — this is what was always expected and USDC has announced full support. PoW can’t be supported because USDC will need an extra dollar for every unit of USDC on PoW.
If stable coins are unsustainable on PoW, pretty much all of DeFi starts to break down. You extend this out enough and PoW seems a very risky bet.
There are also concerns around transacting on the PoW chain. Wallets like Metamask will likely turn off the PoW version to avoid confusion. Centralised exchanges like Coinbase will only support the PoS version to start with. Users will need to be technically savvy, over and above the usual savviness required by crypto, to transact with the PoW version.
Personally, the PoW seems like a risky bet at best. But hey, it makes for a fascinating social experiment.
My money is squarely on the proof of stake version. We’ve waited for this move for a long time. It’s better for the environment, more secure and allows for more participation.
The PoW version of Ethereum is going to happen whether we like it or not. Advocates will claim it provides valuable insurance against the failure of PoS and is more decentralised. But in my mind, it’s because miners want to keep making money.
Only time will tell, but my money is on proof-of-stake.