The Merge Revisited
By: Khalil A. Bryant, J.D.
If you’re a serial email newsletter subscriber like me, then you were waking up every morning during the summer to at least 3 headlines talking about something called THE MERGE. If you read any of them, kudos (I don’t believe you). If you didn’t, I got you!
Although I didn’t want to be a sheep and add to the onslaught of crypto clickbait in your news feed, alas, here I am. As your resident “crypto bro,” it’s not only my right but it’s my responsibility to explain this shit to you.
So, wtf was the Merge, you ask?
Ethereum i.e., “the world computer,” the 2nd most valuable blockchain, and the brain child of Vitalik Buterin, recently transitioned from using a proof of work consensus mechanism to a proof of stake consensus mechanism. The transition was one of five stages in the evolution of the blockchain. According to Buterin’s roadmap for Ethereum, the five phases are: The Merge, The Surge, The Verge, The Purge, and the Splurge.
There are many types of consensus mechanisms, which I won’t get into here. But it’s important to know that consensus is essential to the smooth functioning of any blockchain since it’s what enables them to be trustless.
Blockchains are considered trustless since there’s no policing middle man to make sure one party doesn’t screw over the other party in a transaction. Party A can transact with Party B on a blockchain with confidence, despite the absence of a policing middle man, because the underlying consensus mechanism deters bad actors. Consensus is how a blockchain’s nodes keep an accurate record of transactions to ensure nobody is cheating.
In the context of a blockchain network, cheating is referred to as sybil attacks. A sybil attack is when a hacker undermines a network by creating a bunch of fake identities to gain a large disproportionate amount of influence over the network’s protocol. For example, the infamous “51% attack” is when a majority of a crypto network’s miners or validators collude to restructure the network for their own selfish gain.
Proof of work, namesake of this blog, is a consensus mechanism that uses a competitive incentive structure in which the reward for winning the competition far exceed the costs of cheating.
Bitcoin i.e., digital gold, #1 in the world and #1 in our hearts, and brain child of the pseudonymous Satoshi Nakamoto, uses proof of work and its native coin, bitcoin (BTC), is the reward that miners receive (along with transaction fees) for being the first to successfully solve a complex mathematical puzzle. Solving the puzzle successfully validates a block of transaction and adds it to the immutable chain.
It’s coined proof of work because the energy that’s required to solve the puzzle is what keeps everyone honest. As more nodes compete to solve a particular block, the difficulty of the puzzle increases, which in turn requires greater amounts of energy. Namely, the increasing difficulty prevents a 51% attack from happening since securing that much power becomes prohibitively costly, especially at this point in Bitcoin’s development.
Critics of blockchains utilizing proof of work point to the excessive amount of energy consumption it requires, which is why in recent years the majority of new projects have instead chose to utilize proof of stake.
Proof of stake is different from proof of work because it achieves consensus through a carrot-and-stick type method rather than competition-based incentives.
The carrot is staking, which is when validators lock or pledge their assets/tokens (in Ethereum’s case, Ether (ETH)) into a protocol to receive a chance at proposing the next block and the pledged assets appreciate in value. Validators on proof of stake chains are chosen at random according to the amount of protocol assets they have staked. In other words, a higher amount of staked assets gives you a higher likelihood of being picked to validate the next block. The stick is slashing, where bad validators are punished for acting dishonestly by being forcibly removed from the chain and losing their staked assets.
Since validators on proof of stake chains aren’t actively competing against one another to propose each new block, the amount of energy consumption is exponentially lower. In fact, the Merge was said to lower Ethereum’s energy consumption by more than 99.9%. As a result, the use of ASICs (special mining equipment) is no longer required to participate as a validator and transaction speed is (supposedly) much quicker. (Importantly, transaction fees are not necessarily any different.) Although it may be the case that the energy consumption is just moving to other blockchains and not going away altogether.
On the flip side, critics of proof of stake chains emphasize the lack of proven security compared to proof of work chains as well as the ability for whales to have an outsized influence over a network’s transactions. Moreover, many find issue with the fact that many proof of stake chains require assets to be staked for a minimum amount of time resulting in reduced liquidity.
If decentralization is looked at as a spectrum, then the Merge has undoubtedly caused Ethereum to move farther towards being a centralized blockchain. The transition to proof of stake challenges Ethereum’s decentralization narrative in two ways: 1) it illustrates how the Ethereum Foundation still exercises a high amount of control over its direction, and 2) whales can now exert a high amount of influence over transaction validation.
It will be interesting to see how the potential regulatory treatment of Ethereum changes as a result. In the past, many notable regulators have looked at Ethereum and Bitcoin in a similar light, but the shift to proof of stake fundamentally alters the nature of the Ethereum blockchain. Instead of being viewed as a commodity, it is likely to fall under the definition of a security as defined by the Howey Test.
Hindsight is 20/20,
so it’s important to look at what noteworthy changes (if any) have occurred on Ethereum since the Merge. Since the Merge occurred last month, Ether’s price has declined by 15%, which far outpaces Bitcoin during the same time period. Leading up to the Merge, the price had doubled from its low of the year as other cryptocurrencies continued to decline. This is probably due to traders taking profits on the outsized gains since cryptocurrencies are treated as risk assets and macro conditions have worsened. Another factor contributing to the decline in asset price is the recent regulatory pressure that’s been focused on the crypto industry as bankruptcies and legal woes in the space persist and midterm elections draw near.
Regardless of short term price trends, in the long run, investors in Ethereum can expect the price of ETH to increase since the Merge has reduced ETH issuance by approximately 90%, assuming that traffic on the chain continues to increase over time. Similarly, the implementation of EIP-1559 proposal earlier this year means that a portion of transaction fees are burned, which will also have a positive effect on price. According to Arca, coins utilizing this type of amortization schedule consistently outperform bull and bear markets.
Speaking of traffic, a problem that the Merge didn’t solve is Ethereum’s scalability issues. Since the Merge, the blockchain has still struggled with congestion and transaction fees.
Moreover, according to blockchain development agency Labrys, censorship on Ethereum has been more prevalent since the Merge because relayers are using censorship software to exclude transactions that aren’t compliant with the Office of Foreign Asset Controls (OFAC) requirements. This could become a serious problem in the future if the number of proposers not using censorhip software decreases.
Still, the predominant narrative of the Merge is the resulting reduction in energy consumption. Now that institutions won’t have ESG concerns, they will be more willing to invest in ETH or explore creating their own token on the Ethereum blockchain. While this is positive for mass adoption, it also adds to the concerns surrounding decentralization since institutions with extensive resources can now stake ETH and act as validators, giving them a lot of influence over block validation. Data already indicates that whales, including Lido and Coinbase, control the majority of staked ETH. This centralization of validators increases the threat of a 51% attack.
All-in-all, the Merge was a success in terms of energy consumption, but time will tell whether Ethereum’s transition to proof of stake was the right move for the network in regard to other important aspects such as security, decentralization, and scalability.
New to trading? Try crypto trading bots or copy trading
