Grayscale: Why the Ethereum fork ETHW may not be feasible

Text/Matt Maximo & Michael Zhao grayscale.com

Background

Ethereum is scheduled to merge to Proof of Stake (PoS) on September 15, 2022, which has unsurprisingly sparked speculation about a Proof of Work (PoW) fork of Ethereum (ETHW). While there is precedent for Ethereum forks, we will explore why this time it may not be feasible and what this would mean for Ethereum (ETH) and Ethereum Classic (ETC) .

Ethereum Classic was born in 2016. At that time, there was a vulnerability in the code of an emerging decentralized autonomous organization, or DAO, which hackers exploited to steal more than 3.6 million ETH. While most people in the community supported a hard fork to modify the network's transaction record to invalidate the attacker's actions, some people believed that no changes should be made to the chain state. The forked version of the network became the Ethereum chain we have today, while the group of users who opposed the fork continued to use the version of the network that the DAO attacker successfully attacked, which is now Ethereum Classic.

Since then, Ethereum has developed a strong on-chain ecosystem of decentralized applications (dApps) and user communities, while Ethereum Classic has largely remained a store of value asset. Despite these differences, Ethereum Classic presents a new, proof-of-work variant of the Ethereum network that users, developers, and miners can seamlessly transition to in the event of an Ethereum merge hard fork.

In March 2022, news began to spread about Ethereum miners considering transitioning to Ethereum Classic, causing the ETC price to rise by 103% in 11 days. Despite speculation about a new ETHW fork after the merger, ETC has risen again, up more than 198% since July 12. The speculation surrounding the merger has made ETC one of the best performing cryptocurrencies in 2022, up 18% year-to-date, while other cryptocurrencies such as Bitcoin (BTC) and Ethereum (ETH) have lost nearly 50% of their value.

Source: TradingView as of 8/15/2022

Looking back at history, forked assets have been very profitable, and many of the highest market cap coins started as forks of Bitcoin and Ethereum. For example, in July 2016, when Ethereum (ETH) forked into ETH and ETC, anyone who held a coin on the original blockchain at the time immediately owned an equal amount of the new coin. By the end of 2016, ETC had a market cap of $124 million, making it the sixth largest coin, and ETH had a market cap of $697 million. Today, Ethereum Classic (ETC) is the 19th largest coin with a market cap of over $5.6 billion.

While forks have created value in the past, we will explore why this may not be a viable option for creating PoW.

Ethereum is more than just a currency

It is necessary to distinguish between the Ethereum ecosystem of 2016 (when the network first forked into ETH and ETC) and today's more mature on-chain ecosystem of Ethereum protocols, dApps, and tokens with user experience and interaction. The current PoW fork of the Ethereum network will lead to token duplication, which may pose a major challenge to developers and market participants. In fact, the complexity of DeFi and the number of asset-backed tokens locked in DeFi protocols will pose a catastrophic risk to the price of ETHW as on-chain positions attempt to be liquidated.

To get a detailed idea of ​​how high the risk is today, let’s look at a key element of the Ethereum ecosystem: stablecoins. Stablecoins were just beginning to gain traction when Ethereum Classic forked in 2016. In June of that year, Tether (USDT) had a market cap of just 0.65% of Ethereum (ETH), while at the time of writing this figure is 28.34%.

Source: CoinMetrics, CoinGecko as of 8/15/2022

Tether and other stablecoin issuers, such as Circle (USDC), have stated that only tokens on the PoS network can be redeemed after the fork . This means that all variants on ETHW may become worthless , as well as other "asset-backed tokens" such as wBTC and stETH.

Some of the main use cases for asset-backed tokens are collateral for loans, providing liquidity, facilitating leveraged trading, and other DeFi applications. In 2016, this ecosystem was virtually non-existent. Today, DeFi on Ethereum consists of more than 530 protocols with nearly $40 billion in value locked in smart contracts. Currently, more than $25 billion in asset-backed tokens are locked in smart contracts. If the ETHW fork goes live, users of these protocols may try to leverage their previous asset-backed tokens into ETHW tokens, while ETH holders are simultaneously eager to sell their free ETHW tokens on centralized exchanges for USD or ETH. As a result, we may see disproportionate selling pressure on the forked asset.

Source: CoinMetrics as of 8/15/2022

So far, the speculative market for ETHW that has emerged does not reflect strong support for the fork. The price of ETHW, which can be seen as an indicator of support for a potential fork, has been trending downward since Poloniex launched trading support for ETH IOUs on August 10. ETHW peaked at 0.08 ETH and has continued to steadily decline to 0.03 ETH. While there may be the possibility of a short-term relief rally, the price of ETHW suggests that its support may be driven by speculation rather than the true perceived value of the asset . ETHW is down more than 50% since its launch, while ETC is up about 9% in the same period .

Source: CoinGecko (Ethereum POW on Poloniex) As of 8/15/2022

Unnecessary complexity for protocol teams

In addition to causing the non-redeemable asset-backed tokens on the ETHW chain to lose value, the ETHW fork may also bring new operational problems to many Ethereum-based protocols . When a protocol's token holders vote to deploy on a new blockchain, the circulating supply of the protocol tokens will not change to prevent dilution of value and utility. However, on a PoW fork, the protocol will be copied, and all native tokens will be copied as well. This means that they may trade at different prices than their counterparts on the PoS chain.

Therefore, protocols will need to decide how to manage value tokens held in replicated treasuries, replicated tokens, NFT ownership, etc. How will governance rights be consolidated? Can someone buy a cheaper variant and still have the same voting rights? Will replicated tokens in protocol treasuries be held or sold? Protocol teams may find it much simpler to deploy a new protocol on Ethereum Classic without any token variant issues.

Ethereum Classic’s Bull Run

The success of the ETHW fork requires not only users, funding, and development work, but also strong support from the existing blockchain infrastructure. Major exchanges and DeFi protocols are already deciding whether to support ETHW tokens, although this does not necessarily indicate their preference or endorsement of ETHW technology.

Miners may play a more critical role as the potential ETHW fork is gaining attention. After the merger, miners will no longer be able to receive rewards from the Ethereum network and will seek to move their resources to the new network. With about a month to go until the expected merger, there is still no documentation or expected timeline on how miners will adjust their machines and software to mine on the ETHW chain. In the meantime, Ethereum Classic is fully documented and ready to absorb the current Ethereum mining hashrate.

Ethereum Classic will continue to operate normally regardless of whether the ETHW fork is successful. Supporters of continuing to use the proof-of-work version of Ethereum may find that the complexity of the ETHW fork may not be worth the effort when a stable version of the network exists in Ethereum Classic. While users may be attracted by the promise of free tokens, the ability to liquidate ETHW tokens in USD may be short-lived as liquidity on exchanges dries up. Once an ecosystem has no more value to be extracted, users are unlikely to continue to support it.

Conclusion

Due to the complexity of DeFi and the proliferation of asset-backed tokens, the ETHW fork will face severe challenges. Although the probability of success is expected to be low, some miners and exchanges have begun to support the PoW fork. So far, speculation about the ETHW token has caused its price to steadily fall by more than 50% since its launch, while the price of ETC has risen by about 9%.

In addition to the decline in interest in ETHW tokens, major Ethereum protocols and participants, such as Tether and Circle, have expressed their support for ETH PoS as the canonical chain - an important sign of support as the two companies hold nearly $1201 billion in on-chain assets backing the tokens. If the protocol finds that token holders do want a variant of the protocol on the Ethereum PoW variant, they will likely choose ETC without having to struggle with the complexity of replicating the on-chain ecosystem on ETHW.