Why Ethereum’s Merge Means Crypto That’s Much Greener

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Where does money come from? In the case of dollars, they are printed by the US Mint. For cryptocurrencies, the answer is more complicated. From the time of their birth, the digital tokens with the biggest market value, Bitcoin and Ether, were only issued to pay for tasks performed by so-called miners in what are known as “proof-of-work” systems. It’s an approach that has drawn increasing criticism for the large amounts of energy consumed and pollution produced. That changed on Sept. 15, when Ethereum, the platform that runs the Ether coin, switched to a system called “proof of stake” in a major upgrade known as the “Merge.” Proponents say the approach will cut Ethereum’s electricity use by 99%. 

1. What are the ‘proof of’ systems for?

Cryptocurrencies wouldn’t work without blockchain, a relatively new technology that performs the old-fashioned function of maintaining a ledger of time-ordered transactions. What’s different from pen-and-paper records is that the ledger is shared on computers all around the world. Blockchain has to take on another task not needed in a world of physical money — making sure that no one is able to spend a cryptocurrency token more than once by manipulating the digital ledger. Blockchains operate without a central guardian, such as a bank, in charge of the ledger: Both proof-of-work and proof-of-stake systems rely on group action to order and safeguard a blockchain’s sequential record.

Until the Merge, in both the main Bitcoin and Ethereum networks, transactions were grouped into “blocks” that were published to a public “chain,” but only after proof-of-work ordering was performed. With Bitcoin’s software, that happens when the system compresses the data in the block into a puzzle that can only be solved through trial-and-error computations that can potentially need to be run millions of time. This work is done by miners who compete to be the first to come up with a solution and are rewarded with free cryptocurrency if other miners agree it works.

3. What are proof of work’s drawbacks?

When Bitcoin and Ether were worth pennies, mining was also cheap. But as the value of the currencies rose, an arms race of a sort set in, as miners poured in resources in the quest to win new coins. The Bitcoin system’s software responded to increased competition by revving up the computational difficulty of the blockchain puzzles. The resulting sky-high electricity usage led to calls from the environmentally conscious to shun Bitcoin and Ether. The European Union considered banning proof-of-work practices before deciding that cryptoasset providers should be required to disclose the energy consumption and environmental impact of the assets they choose to list. The proof-of-work system has also led to a growing dominance by huge, centralized mining farms, a development that’s created a new vulnerability for a system designed to be decentralized. In theory, a blockchain could be rewritten by a party that controlled a majority of mining power.

4. What is proof of stake?

The idea behind the proof-of-stake system adopted by Ethereum in the Merge is that its blockchain can be secured in a different way: by giving a group of people a set of carrot-and-stick incentives to collaborate on the task. People who put up, or stake, 32 Ether (1 Ether traded at around $1,600 on Sept. 14) can become “validators,” while those with less Ether can become validators jointly. Validators are chosen to order blocks of transactions on the Ethereum blockchain. If a block is accepted by a committee whose members are called attestors, validators are awarded Ether. But someone who tried to game the system could lose the coins that were staked. Ethereum’s proof of stake system was first tested on a blockchain called the Beacon Chain that was separate from the proof-of-work system. The two blockchains were merged in the Merge.

5. What are the system’s advantages?

Switching to proof of stake should cut Ethereum’s energy use — estimated at 45,000 gigawatt hours per year, or a bit more than New Zealand’s — by 99.9%. In terms of its carbon footprint, it would essentially be like any other internet operation whose energy use involves nothing more than running a network of computers, rather than a venture resembling a collection of gigantic digital factories.  

6. What are its vulnerabilities?

Proof of stake is less battle-tested than proof of work, whose security has been scrutinized for more than a decade. So new vulnerabilities could be found. Also, there’s a risk that an additional new player in the Ethereum ecosystem could become dangerously powerful: the so-called builder. Builders do the work of packaging transactions into blocks and relaying them to the validators. There are more than 420,000 validators currently but only a few builders. If a major provider of crypto wallets, software for transferring and storing coins, decides to send all their transactions to a particular builder, that builder may be able to censor transactions and command high prices. Proof-of-stake proponents think the risks are worth what would be gained in terms of environmental benefits, as well as from bringing a broader group of users into the process than was possible when becoming a miner could involve a big outlay for specialized computers. 

7. What kind of issues could come up in the Merge?

Major software upgrades almost never go smoothly. Despite years of testing prior to the Merge, various bugs and issues could potentially crop up in the weeks and even months after the switchover. Some of these issues relate to so-called forks — copies of Ethereum that are expected to spring up that will still be using miners. Because of these forks, there’s the danger of replay attacks, in which hackers repeat a user’s transaction executed on one chain on the main, proof-of-stake Ethereum network to steal coins. While Ethereum has been hardened against such attacks, some applications running on the network may not have included the necessary protections in their code.

8. Will the Merge change the Ethereum user experience?

No, the Merge won’t change network transaction costs or speed. But it does lay the foundation for future software upgrades that supporters of the platform hope will improve both.

9. If the Merge succeeds, what will this mean for proof-of-work blockchains?

If the new Ethereum system starts working well, it could put more pressure on other proof-of-work systems (notably Bitcoin’s) to switch to a more energy-efficient process as well. Environmental concerns surrounding such blockchains have long prevented large companies and funds that are committed to fighting climate change from investing in crypto. Ethereum’s hope is that once the platform becomes more environmentally friendly, more institutional investors will give its coin, Ether, a second look, and more developers who avoided building finance, gaming and other applications for the network due to its high energy consumption will move over. This could potentially result in something cryptoheads call “flippening” — essentially, Ether’s market capitalization exceeding Bitcoin’s for the first time. Before the merge, Bitcoin’s value was about double that of Ether. 

10. How could the Merge change the economics of Ether?

By changing the properties of Ether, the Merge will make it more akin to yield-bearing securities. Staked Ether will generate a return, expected to be around 5.2% right after the Merge, according to tracker Staking Rewards. Coupled with an expected net decrease in Ether token supply, possibly some months after the update, that should make the coin more attractive to investors. Today, only about 11% of Ether in circulation is used in staking on Ethereum. Eventually, around 80% of the Ether may be staked, meaning that it will be locked up for a period of time. That could have implications for Ether’s long-term pricing and liquidity.

11. What does it mean, that staked Ether is locked up?

Ethereum has to undergo yet another software upgrade — expected to happen at least six months from the Merge — before staked Ether can be withdrawn. Even then, withdrawals will be capped. So investors are taking on a lot of risks when locking up their Ether.

More stories like this are available on bloomberg.com

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Olga Kharif

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