Ethereum Aims to Become Crypto Internet with ‘The Merge’

Whose


Bitcoin

is crypto’s answer to gold, Ethereum is the closest thing it has to its own internet. Anyone looking to mint a new token, launch a crypto app, or spend $150,000 on a Bored Ape nonfungible token, or NFT, is likely using the Ethereum network. More than $3 billion in transaction volume flows through Ethereum daily, traded in the network’s native token,


Ether.

About $60 billion in crypto assets sit on its blockchain through third-party apps. Aside from Bitcoin, no other network is more critical to crypto’s infrastructure or its future.

Messing around with Ethereum is no small thing. Still, the network’s developers aren’t just tinkering — they’re on the way to overhauling the plumbing and mechanics of Ethereum in an upgrade enthusiasts are calling The Merge.

The change, scheduled to happen around September 15, is a major technological risk and could be a transformative moment for crypto. Companies like it

Coinbase Global

(ticker: COIN) will feel the impact almost immediately. And there will likely be ripple effects throughout the industry, affecting everyone from crypto miners to chipmakers such as

Nvidia

(NVDA) and investors with some Ether in their portfolios.

“The merge is the most significant upgrade in crypto history,” said Sami Kassab, an analyst at crypto-analysis firm Messari. “It’s like changing the engines on a plane mid-flight. A mistake in the code could wreak havoc on the crypto ecosystem.”

Years in the making, The Merge could be crypto’s answer to critics who say the industry is a colossal waste of energy. Ethereum, with a market cap of nearly $200 billion, now uses the same method of validating transactions as Bitcoin.

In that process, known as proof of work, computers compete to solve cryptographic puzzles. The network reaches a consensus on the winner, proving that a block of transactions is valid and should be added to the chain. The winner then receives some Bitcoin, a practice known as mining.

It is very energy intensive and requires a huge amount of computer work and electricity. Ethereum was built on the same system, and it’s also an energy hog, using roughly the same amount of electricity in a year as countries like the Netherlands.

Now developers are scrapping that model and moving to a much greener system for processing transactions called proof of stake. Instead of mining, Ether owners use their tokens as collateral to validate transactions and “pitch” them to the network in exchange for a dividend paid with the Ether token. To participate, a staker must deposit 32 Ether tokens worth about $50,000 and run some software. The system randomly selects validators, like a lottery. Crypto exchanges and other companies operate staking pools so that anyone can participate with smaller amounts of Ether.

The switch was supposed to eliminate Ether mining. By doing so, it will cut Ethereum’s energy consumption by more than 99%, according to the Ethereum Foundation, greatly reducing the network’s carbon footprint.

It’s just the start of a major makeover. The merger was also supposed to reduce the newly minted ether produced each year. And developers are planning several upgrades over the next few years aimed at increasing Ethereum’s throughput and lowering its usage fees. Ideally, they aim to turn Ethereum into the crypto-internet – a base layer for apps, financial services and many more digital assets like NFTs.

“Today we are talking about decentralized economy. In 10 years, if we’re successful, people will just call it finance, period,” says Justin Drake, a researcher for the Ethereum Foundation who is helping with the project. “For almost any financial transaction, they will use Ethereum.”

Still, The Merge can also have victims. It may cause errors, outages or loss of tokens as the current Ethereum blockchain merges with a new one, called Beacon. “A laundry list of items will need to continue to operate seamlessly post-Merge to keep exploits and liquidations at bay,” said Sean Farrell, head of digital assets at Fundstrat Global Advisors.

The stakes are high because so much of the crypto industry has a stake in its performance — from exchanges like Coinbase to mining, NFT platforms and stablecoin issuers. “Usually when you push a change to a website and it breaks — well, it’s not the end of the world. In this case, you could lose a lot of money,” said Katie Talati, director of research at Arca, a crypto-asset manager .

The most immediate effect could be on Ether’s price. Since mid-June, the token has risen more than 50%, while Bitcoin has remained flat. Both tokens are down around 60% this year under pressure from rising interest rates and weaker demand for highly speculative technology.

A successful merger could make Ether ripe for another run, some analysts say. This is partly because moving to Proof of Stake should reduce token issuance to around 0.5% per year, down from 4.5% currently. A reduction in the issue can push the price up. “In the current market, supply and demand are relatively in balance,” said Steve Goulden, senior analyst for Cumberland, the crypto arm of trading firm DRW Holdings. “After the merger, there will be a significant supply deficit.”

Meanwhile, demand could get a boost as owners stake their tokens in return for a dividend. Investors can earn 4% to 8% by betting, depending on how much revenue the network generates and other factors, according to Talati. Institutional funds with a mandate to invest in environmentally friendly assets could also buy Ether as blockchain’s carbon emissions become less of an issue.

The upgrade could be a boon for companies like Coinbase. The exchange is developing a service that makes it easy for investors to stake their Ether, with Coinbase taking 25% of any income generated. The stakes business has already “grown into a major source of subscription and service revenue and is growing nicely,” CEO Brian Armstrong said on an earnings call in August.

However, as in any technical upgrade cycle, there will be a legacy of obsolescence. Some of the biggest losers in this cycle could be mining companies that spent hundreds of millions of dollars on hardware that could be rendered worthless. Executives at Hut 8 Mining (HUT), which mines both Bitcoin and Ether, said in August that they were studying how to adapt their Ether mining machines to other tokens or projects.

Hive Blockchain Technologies

(HIVE), another miner, said a shift to proof of stake “could make our mining business less competitive.”

Chipmaker Nvidia looks like another victim. The company’s graphics chips and cards have been adopted by the industry to mine Ether. But demand now appears to be evaporating. Nvidia, whose stock is already suffering from a slowdown in gaming and other core areas, said on its latest earnings call that it could not predict how reduced crypto mining could hit demand. Analysts for investment bank Baird say The Merge is likely to “generate a wave of mining GPUs [graphics processing units] on the used market, exacerbating inventory problems.”

In the longer term, Ethereum may pose a greater threat to rival blockchain networks. Blockchains and tokens like Solana, Avalanche and Tezos launched with the promise of being faster and more efficient than Ethereum. All run on proof of stake and have established various uses, but if Ethereum pulls its upgrades, they may run out of time to prove their relevance. “Now that Ethereum has achieved proof of stake, there is less of an argument for many other blockchains,” says Kassab.

Some crypto companies are not taking The Merge lying down. The threat has prompted a few miners to launch a competing Ethereum blockchain, called a fork, using the proof-of-work method. The idea is to create an Ether spinoff and a parallel universe of smart contracts, NFTs and decentralized finance, or DeFi, applications.

The potential for dueling Ether blockchains forces companies to choose sides or declare neutrality. Exchanges such as Coinbase, Binance and FTX say they will apply their usual listing standards to forked tokens and may allow them to trade. Creators of crypto apps such as Uniswap, Compound and stablecoin USDC have pledged to only recognize the new Ethereum blockchain.

An Ethereum split has some crypto leaders worried that fraudsters may find new ways to perpetuate theft and fraud. “Someone is going to spend 80 real Ether on a fake Bored Ape,” says Robert Leshner, founder and CEO of Compound Labs, a DeFi company. “There will be all kinds of disasters,” he says, advising investors to wait for the kinks to be worked out and “do nothing.”

Another unknown is how Washington will respond. Officials at the Securities and Exchange Commission have indicated that Bitcoin and Ether should be treated as commodities — potentially removing these tokens from SEC oversight. But because many investors will buy Ether with the expectation of a return, some advocates believe it could make the token more like a security. If the SEC agrees, crypto exchanges like Coinbase could be vulnerable to lawsuits or enforcement action if they let it trade on their platforms anyway.

Changes of this magnitude are an “opportunity to try to distinguish the previous analysis from the current analysis,” said Teresa Goody Guillén, a partner at BakerHostetler and former SEC attorney, who believes that Ether would still not qualify as a security . The SEC declined to comment.

As with all things in crypto, the hype surrounding The Merge already exceeds the reality. Advocates say it could be the start of a renaissance of useful apps and services — finally silencing critics baffled by a multibillion-dollar industry that has yet to find a raison d’être beyond speculation. Conversely, if it flops, it would be another setback for a technology long on complexity and short on the real world.

“The most important part of The Merge is the narrative,” says Kassab. “It’s something that everyone is talking about that could bring people back to Web3 and crypto, assuming it’s successful.”

The crypto market is now suffering from a crisis of confidence, having lost $2 trillion in value over the past year and drawing the ire of governments worldwide. A successful merger may not revive the market or its reputation. But it could at least make crypto a little greener on its way forward.

Write to Joe Light at joe.light@barrons.com

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