When Bitcoin was launched, it had ambitions to become a peer-to-peer payment system powered by electronic cash. It is yet to fulfill that promise.
Ethereum, another monetary system underpinned by blockchain, has much grander ambitions. Released six years after Bitcoin’s, Ethereum’s whitepaper outlines a raft of ambitious applications – a platform for financial derivatives to voting mechanisms to decentralized governance that works across borders – that are possible once the blockchain reaches its full potential.
A key step to reaching that goal occurs tonight. In roughly ten hours, the blockchain will transition from the energy intensive Proof of Work (PoW) consensus mechanism to one that consumes significantly less energy and sets the stage to make it scalable enough to handle more transactions. The transition to Proof of Stake (PoS), the new consensus mechanism, is called The Merge because it involves the merging of two chains – a test chain and the actual Ethereum blockchain – and it will occur at 5 a.m. Universal Coordinated Time (UTC).
A Media Event
The Merge has generated considerable media and investor attention. Ether, ethereum’s cryptocurrency, became an outlier in crashing crypto markets as excited investors poured money into the asset. Its price rallied in the weeks leading up to today’s event. However, in a classic case of “buy the rumor, sell the news”, investors are exiting their trade as the event draws nearer. Since yesterday, its price has fallen by almost 9%.
Trading strategies were specifically crafted for The Merge. The universe of derivatives around Ethereum is also growing in anticipation of an increase in its ability to handle transactions in the future. Interest rate swaps on Ethereum have made their debut. The Chicago Mercantile Exchange (CME), the world’s biggest derivative exchange, launched trading in ether options last week. According to Tim McCourt, Head of Equity and FX products at the exchange, the move was driven by excitement about The Merge. “There is more distinct enthusiasm around ether,” he told Coindesk.
Benefits of The Merge
No doubt, the move from PoW to PoS is important in the cryptocurrency’s evolution. It is expected to reduce energy emissions from Ethereum’s network by an estimated 99.95%. It will also enhance security by reducing the investment amount needed to become a validator in the network.
More Ethereum full nodes that contain entire copies of blocks of transactions will convert ether into “ultrasound money”, according to developers. Ethereum’s soundness has been tested before and it failed that test: a hacker made away with millions of ether tokens in 2016. An environment-friendly blockchain might also make ESG investors more amenable to putting their money into it. Down the line, the transition will also make it easier to implement database partitioning – a necessity to ensure scalability of the network.
A Problem of Centralization
But the Merge also creates new problems and leaves old ones intact.
In fact, in its new avatar after tonight, the Ethereum blockchain will have most of the problems of its old one. [The old Ethereum chain will continue until the new one can take over. Plans are already being made to mint profits from the old Proof of Work (PoW) chain even though it has no verifiable use case in the new scheme of things].
The centralization of validators is one. The PoS system encourages accumulation of ether, also known as staking, to run as many nodes as possible to earn more rewards. Thus, the more nodes you run, the greater your chances of earning ether – an asset that is expected to become dearer in the coming years – as reward. Solana, another PoS blockchain, is already considered a fairly centralized chain by crypto observers.
The contours of Ethereum’s validator makeup have already begun to emerge. According to a report from online publication The Block, staking pool Lido Finance has 90% share of the total share among such pools while three exchanges – Coinbase, Kraken, and Binance – are responsible for 95% of the total among cryptocurrency exchanges.
Even with the promised move towards stateless nodes – nodes that do not contain entire blocks of transaction states – in the future, the problem of centralization will persist because full nodes are essential to the blockchain’s functioning. The costs of setting one up and maintaining it will become more expensive as the number of transactions on its network surge and act as a barrier to entry for individual or small validators. Philosophically then, PoS is no different from PoW in that the rewards accrue to those with more resources.
A Question of High Gas Fees
Ethereum’s bloated transaction fees, the amount required to conduct a transaction on its network, and frequent congestions are also not solved by the current transition. Ethereum co-founder Vitalik Buterin has said gas fees in the network should be between $0.002 and $0.005. Currently, transaction fees average between $2.15 at NFT platform OpenSea and $5.55 at UniSwap.
Transaction fees on Ethereum are high because it has limited space to include transactions. After the Merge, the block size will increase only marginally, meaning transaction fees will continue to remain high. A successful implementation of sharding or database partitioning takes place that transaction fees will begin sliding because it will allow for more storage in the overall system. But the timeframe for sharding is still unclear.
Of course, this is not to say that tonight’s transition is not important in the context of Ethereum’s history. In less than eight years, the small and tight knit team of Ethereum developers has managed to craft a blockchain system that might one day form the rails of a new financial system.
An ecosystem of applications, including NFTs and derivatives, has sprouted on it. The demands of storage and bandwidth from these applications have forced Ethereum to confront its limitations. The Merge is the first step in Ethereum’s maturity as a platform.