The Economist: Ethereum merger imminent, the future of cryptocurrency at stake

At 2pm UTC on August 18, people around the world were dialing into the biweekly “core developers” Zoom call , which would be livestreamed on YouTube to anyone who wanted to watch. None of the participants had their cameras on, and most appeared as black squares with names on them—including one named Vitalik, which posed as Ethereum’s inventor, Vitalik Buterin.

A handful of users adopted panda avatars, cartoon faces swaying and smiling in front of their human counterparts. They chose this avatar thanks to Ethereum researcher Hsiao Wei Wang. He created a meme that shows two bears, one black and one white, doing the "fusion dance" from the popular anime Dragon Ball Z. In the performance, the two bears merge into a more powerful individual as they dance. The panda - a combination of two bears - has since become a symbol of "merger."

The merge is the name the crypto community gives to the point in time when the Ethereum blockchain will transition from using "proof of work" as a consensus mechanism to using "proof of stake." They call it a merge because for nearly two years, a separate proof-of-stake blockchain called the Beacon Chain has been running alongside the original Ethereum chain for developers to test, improve, and test again. The Zoom meeting is for developers to agree on when the two chains will merge. The date and time of the merge will depend on how much computer power is used to maintain the blockchain, but the merge should occur around 1 a.m. UTC on September 15.

This is more than just a technical tweak. It’s a complete overhaul of a seven-year-old, $200 billion software, and if all goes to plan, it will be implemented without downtime. People in the crypto space like to compare the process to changing the engine of a plane mid-flight. Proof-of-work is energy-intensive and requires a lot of computing power, which has led to blockchains like Ethereum and Bitcoin consuming as much energy as small countries. Proof-of-stake could reduce energy consumption by 99.9%. The impact on emissions will be felt overnight, and Ethereum is expected to be shut down in the Netherlands after the merger (see chart). More importantly, if the merger is successful, it will show that Ethereum has the ability to improve itself, opening the door to more radical changes.

Cryptocurrencies need good news, as the past year has been a rough one. A handful of unreliable deposit-taking ventures have collapsed; a crypto hedge fund has gone bust; and stablecoins have been found to be anything but stable. The total market capitalization of cryptocurrencies has fallen to about $1 trillion, about $2 trillion lower than it was this time last year. Ethereum’s improvements won’t eliminate this destructiveness, but by reducing its environmental impact and highlighting its potential for future improvements, it will show that the future of cryptocurrencies is brighter than people currently believe.

Buterin first published the idea for the Ethereum blockchain in 2014. Like Bitcoin, it is a large database that records every transaction that has ever taken place with the cryptocurrency. But Buterin's key insight was that a blockchain could do much more than that - it could also track lines of code. This allows Ethereum to record the transfer of currency, as well as the transfer of all assets and functions maintained in "smart contracts." A "smart contract" is a self-executing agreement that triggers a series of actions when certain conditions are met. With Ethereum verifying the code, developers can build a large network of financial institutions, such as exchanges and lenders, in code on the Ethereum blockchain.

The blockchain is maintained by more than a dozen pieces of software called “clients,” which are developed by core developers. Clients are built in a variety of programming languages, including Go, Rust, Java, and C#, and the software is run by “nodes” — computers that run the client software to maintain the history of the Ethereum blockchain. All decisions about what to do and whether to implement upgrades are made by consensus among developers, ether holders, and people who build applications on Ethereum or list real-world assets on the blockchain. Any plans and code are published live on GitHub, a repository for programmers. Core developers meet every two weeks to discuss potential upgrades. In theory, anyone can become a core developer by developing software.

The result is a motley crew of developers. Some are employed by companies like ConsenSys, a Brooklyn-based blockchain software company founded by Joe Lubin, one of a handful of people who helped create Ethereum after Buterin published his white paper in 2014. Some are employed by the Ethereum Foundation, a nonprofit founded in Zug, Switzerland, in 2014. Ethereum is not a company, and Buterin has influence and importance as its founder, but not as its CEO. It is open source — much like the free operating system Linux and the web browser Firefox — but offers an incentive for developers to participate in its maintenance by the ability to buy a stake in it using ether, but the extent to which its governance is truly decentralized is not entirely clear. At the start of the project in 2015, Buterin said he did a lot of research, thinking about what Ethereum should be, and a lot of coding to make it happen. By 2020, he said he had done maybe a third of that research, very little coding, but mostly “high-level theory.” Over the past two years, he has said, even the high-level theory “has been slipping away from me, slowly but surely.”

To pull off a change like a merge requires enough consensus among all parties involved. All major clients must agree to update their software, enough nodes must also update their software, and all real-world applications on the blockchain — like stablecoins backed by dollars in bank accounts — must accept the new merged chain, which will preserve the state of their assets. Watching this all happen in real time was surreal. It was as if The Economist began livestreaming its editorial meetings and allowing subscribers to commission articles and choose covers.

Not all stakeholders are in favor of the merger. Miners have invested $5 billion in hardware to run the proof-of-work consensus mechanism. Around September 15, the hardware will no longer provide them with much return. The way proof-of-work maintains the security of the blockchain is by incentivizing hundreds of thousands of computers to solve a mathematical puzzle. The computer that finds the solution first alerts the other miners, and if they confirm the result, they update the blockchain and get paid. So in the lovely, new world of Ethereum, it pays to have a lot of graphics cards.

Proof of Stake works by having cryptocurrency holders vote on whether to update the blockchain. Voting power, and therefore a share of rewards, depends on how much Ether is staked. If stakers misbehave, such as by making the wrong transactions, their stake can be destroyed. So on September 15, the advantage of having a lot of graphics cards will disappear. Instead, the advantage will be holding Ether.

Miners may try to delay the merge by rebelling. But the nodes mostly seem to be cooperating with the update. According to ethernode, a website that tracks Ethereum activity, about 75% have updated their software to prepare for the merge. Another option is to try to "fork" the blockchain, by still running the old software and hoping that enough people do the same thing, the old version of the blockchain will continue to exist. A hack in 2016 caused Ethereum to split into two chains: Ethereum (the dominant chain) and "Ethereum Classic" (a much smaller chain).

Justin Drake of the Ethereum Foundation said that for the split, “basically one miner in the world needs to decide they want to continue using proof-of-work,” meaning there will almost certainly be one such miner. The question is how many miners stick around, and how many will give up. Chandler Guo, who backed the ethereum classic fork in 2016, is trying to organize miners around a proof-of-work token called “ETHW.” “I forked ethereum once, and I’ll fork it again!” he said. While miners have reasons to stick with the old ways, the economics of trying to fork the chain may not add up. Mining ETHW would only make sense if the value of the token was high enough.

Institutions like stablecoin operator Circle have backed the new approach over any forks. In a statement on August 9, the company said it “intends to fully support Ethereum’s proof-of-stake chain after the merger.” Wallet operators and exchanges also support the proof-of-stake chain.

These dynamics reveal the inherent balance of power in Ethereum. Developers can’t make an update that’s universally loathed, because doing so would result in a messy fork; miners can’t reject an update if everyone else supports it. Decisions made by those running apps on the blockchain, like Circle, can help resolve disputes between the two camps. This is very different from traditional tech platforms. Apple can push out an update that both iPhone users and app developers dislike, and there’s little either group can do about it short of abandoning the iPhone entirely. There’s no such thing as a “forked” iPhone.

The way ethereum reaches consensus is "a messy and ad hoc process," Drake acknowledged. But if things work out well, there will be huge benefits. As ethereum is mined around the world, the impact of its energy needs being eliminated overnight will not be huge. Almost half of ethereum's nodes are in the United States; about a tenth are in Germany. Other countries, like Singapore, the United Kingdom, and Finland, have less than 5%. But in smaller countries where mining is very popular, like Singapore, energy prices could fall.

The change also reduced demand for specialized mining hardware. Chipmaker Nvidia makes gaming graphics cards that can also be used for mining. From May to July, partly because of rumors of an impending merger, its chip revenue fell by half from the previous three months. On eBay, prices for used graphics cards are plunging.

Since the network won’t require as much energy and hardware to maintain, the rewards for validating transactions can be reduced. “Under proof-of-work, the scarce resource that’s provided in return is computing power. That’s very expensive because you have to pay for electricity and hardware costs,” Drake said. With proof-of-stake, the scarce resource is the digital currency. “So the maintenance cost is essentially the opportunity cost of that money, which might be 3% or 4%.” As a result, the number of tokens Ethereum will pay out to stakeholders after the merge will be just 10% of the number of tokens it paid out to miners before the merge.

This change in the monetary system may be one reason why the price of ether has surged since the merger began to be determined in mid-July. The currency has risen nearly 50% even as bitcoin and other crypto tokens have traded sideways. Ethereum supporters believe that a successful merger could pave the way for a "turnaround" that would see ether surpass bitcoin in market value for the first time. It is currently worth about half of its rival cryptocurrency, close to its highest share since 2017.

Another big benefit is security. Currently, to take control of the Bitcoin or Ethereum blockchain, an attacker would need 51% of the total computing power needed to mine the currency. A rough estimate puts the cost of such a move at $5 billion to $10 billion. To attack a proof-of-stake blockchain, half of all tokens would need to be acquired and held, which would cost around $20 billion.

Some have argued that these benefits will come at the cost of concentrated power, since under proof-of-stake, large shareholders receive more rewards for further increasing their holdings. But Ben Edgington of blockchain software company ConsenSys says that’s a false narrative. Smaller shares will earn less than larger ones, but their proportion of total circulating tokens will remain constant over time, meaning their relative power won’t increase. Under proof-of-work, there are also returns to scale from building larger, more efficient mining rigs. But “people can’t build a competitive mining rig at home,” Edgington noted.

Another risk is that the transition fails in some way, which could undermine public support. Lubin, Ethereum’s co-founder, takes this in stride. “We’ve done a lot of testing, and I think the blockchain element is going to work very smoothly,” he said. Edgington believes the only possible missing link in the transition is the broader community. Given the complexity of installing new components and the need to master new ways of working, some participants may churn. But he said that problems would only arise if the churn rate exceeded 40%, which is unlikely. However, applications running on the blockchain, such as exchanges, may encounter some problems. Major software updates have revealed various bugs in code that previously seemed to work well. Some important DeFi applications, such as lending platform Aave, are preparing to suspend ether trading during the merger.

If all goes well, the merger will be a step toward more useful technology. Many financial applications that run on blockchains are highly efficient, in part because they automate the functions of the financial system. Smart contracts automatically match buyers/sellers or borrowers/lenders on an exchange. An IMF paper found that the marginal cost of financial intermediation through DeFi applications is about one-third that of banks in rich countries and one-fifth that of banks in emerging markets. However, the speed and cost of using the Ethereum blockchain could hinder users' efficiency. When the network is busy, the fees for recording transactions are called "gas fees," and a single transaction can cost as much as $100.

The merged upgrade is primarily designed to improve scale and efficiency. At an Ethereum conference in Paris in July, Buterin joked that the path of blockchains is first "merger," then "surge," "edge," "cleanse," and "squander." The "surge" here refers to "sharding," the process of splitting a database into multiple blocks to spread the load. This will allow the blockchain to handle more transactions and will reduce the fees required to use it. "Today's Ethereum can handle about 15-20 transactions per second. This Ethereum...it will be able to handle 100,000 transactions per second," Buterin declared.

The “edge” will implement a new type of mathematical proof called “Verkle trees” and enable “stateless clients.” This will mean someone can run software to operate a node without having to store the entire “state” of the blockchain, which is a huge amount of data. The “scrubbing” will remove old data from the blockchain’s history. The “squandering” is “all the other fun stuff,” which could be anything Buterin and the crypto head honchos like. A successful merger is the first step to making all of these changes happen. It will prove that decentralized groups of people can do risky, controversial, and important things. It’s time to see if they can do it.